The 1996 reform of the electricity supply industry in The Netherlands

UtilitiesPolicy,Vol. 6, No. 2, pp. 117-126, 1997 Pergamon PII: S0957-1787(97)00005-2

© 1997 Elsevier Science Ltd. All rights reserved Printed in Great Britain 0957-1787/97 $17.00+0.00

The 1996 reform of the electricity supply industry in The Netherlands Gert Brunekreeft

This paper describes and assesses a proposal presented by the Dutch Department of Economic Affairs in July 1996 for structural reform of the electricity sector. First, the reasons for reform are described. Second, the reform proposal itself is described. The main features are the creation of a dominant generation firm by merger of the current four generation firms and free entry at the stages generation and distribution-service. Confusingly, the sector will be structurally separated in intention, but not in ownership. Finally, a critical assessment concentrates on the dominant generation firm and the intentionally voluntary dispatch, and remaining regulatory issues. © 1997 Elsevier Science Ltd. Keywords:Electricity; Regulation; The Netherlands Introduction

In July 1996, the Department o f Economic Affairs in the Netherlands published a report with a concept for reform in the Electricity Supply Industry (ESI) in the Netherlands. This report can be seen as a white paper and is called "Stroomlijnen naar een markt voor elektriciteit; Opzet voor een nieuwe elektriciteitswet''~. From this white paper, a proposal for a new law has been derived in N o v e m b e r 1996 and will be sent to Parliament early February 1997. The white paper followed, what might be seen as a green paper, the so-called "Derde Energienota ''2 presented by the same department in December 1995, which intended among other things to evaluate the existing structure, set out a possible new structure and invite discussion on this issue. The current structure of the electricity sector in the Netherlands is based on the electricity-act of 1989 (Elektriciteitswet, 1989) 3, which had already reformed the structure rather thoroughly and G. Brunekreeft is with the Institut fur Verkehrswissenschaft und Regionalpolitik, Albert-Ludwigs-Universit~itFreiburg, Platz der Alten Synagoge, D-79085 Freiburg i.Br., Germany.

as it turned out much to the dissatisfaction of the parties involved. As soon as the first formal evaluation of the law, it became clear that new reform, or at least substantial modification might be desirable. In the five or six years of actual operation of the electricity-act of 1989, it quickly turned out that it incorporated some severe inconsistencies. Two aspects seem to be of special interest. First, the electricity-act of 1989 more or less induced excess capacity and second, soon after its implementation there seems to have been a major shift in bargaining power from the generators to the distributors. In this paper, I will briefly sketch the current structure as set out by the electricity-act of 1989 and the problems which induced the reassessment of its operation. After this brief historical sketch, Section 3 presents the outline as set out in the white paper (MinEZ, 1996). At appropriate places a comparison will be made with the "Derde Energienota" (MinEZ, 1995), which as mentioned can be seen as the preceding green paper. The main characterization of the proposed new structure is (1) the expansion of market mechanisms, (2) preparation for an open European internal market and (3) vertical cooperation to cope with the threat of excess capacity. In more detail, • Entry will be free at the stages generation and supply. • The present four generation firms will merge into one 'national champion', owning approximately 77% of total generation capacity. • It is intended to structurally separate the entire infrastructure network. • The existing ownership structures will be maintained. Section 4 will try to critically assess some o f the aspects of the concept in the white paper, notwithstanding the low degree of detail in both the green and white paper. Consequently, the evaluation, as well as the description, concentrate on the broad structure, stressing however, 117

Reform of the electricity sector in the Ne'therlands

that the success or failure of any new structure may critically depend on the details. The list above clarifies that the proposed concept for reform pushes the sector more to the model set out in the United Kingdom or depending on the details the Nordic countries 4. There are some remarkable differences, however. Section 5 will summarize conclusions and recommendations.

Brief historical sketch The electricity sector in the Netherlands before 1989 was highly vertically integrated, with clearly defined closed service areas. Moreover, the sector was and still is stateowned; that is, shareholders are provinces and municipalities, which is lower-tier government. In 1989 a rather thorough reform took place resulting in the electricity-act of 1989 (Elektriciteitswet, 1989). From an economic point of view, the most prominent underlying rationale was that competition (at especially the generation stage) might increase the sector's efficiency (see e.g. Joskow and Schmalensee, 1983 p. 51 and LoozenMeulendijks, 1990 p. XIV). By restructuring the sector, competition might be allowed at this stage. The main feature of the electricity-act of 1989 was to introduce a quite restrictive form of internal competition; that is, competition between incumbents, since entry was hardly allowed. Nevertheless, introducing some competition in the second half of the 80's might be called progressive and exemplary. The sector has more or less been vertically disintegrated in three stages: Generation, transmission and distribution. A fourth stage might be distinguished in the form of coordination of generation. This has technical as well as economical reasons. Technical coordination is 'merely' necessary to monitor the technical well-functioning of the system. The economic part of the coordination may be called economic dispatch and pursues to minimize systemwide short-run production costs 5. To be sure, some central institution decides, following whatever rules are laid down, which generator is going to produce how much and when. Transmission, which is high-voltage transport, and both coordination tasks had been laid in the hands of an institution called SEE which is an abbreviation for "Samenwerkende Elektriciteits Produktiebedrijven ''6. The second tier of the efficiency considerations of the electricity-act of 1989 is scale enlargement; at the generation stage, existing generation companies were to merge until only four so-called centralized generation companies remained. The electricity-act of 1989 makes an explicit distinction between centralized and decentralized generation. The four centralized generation companies are licensed by law and should have a minimum capacity of 2500 MW. Subsequently, entry is restricted implying that these four licensed generators

118

have the exclusive right to produce electricity on a large scale (i.e. turbines with a capacity above 5 MW) using fossil fuel or nuclear energy (Elektriciteitswet, 1989 art. 3). Decentralized generation stems from co-generation, independent producers and distributors, using smallscale fossil-fuel turbines, or small- or large-scale turbines using renewable energy sources. In turn, the generators are not allowed to serve end-users (Elektriciteitswet, 1989 art. 4-2c). In 1995, of a total capacity of approximately 18.6 GW, the four licensed generators owned about 14.4 GW (=77.4%). This leaves 4 . 2 G W for decentralized capacity, which is twice as much as in 1990 (SEP, 1996a p. 5, 16). To compare and to get a feel for what might be called excess capacity, the highest demand at any time in 1995 was 11.16 GW (SEP, 1996a p. 5). The major part of the decentralized capacity is so-called Combined-HeatPower (CHP); somewhat more than 80%. Estimates for CHP-capacity in 2006 range from 4.2 to 5.9 GW (SEP, 1996c p. 16). It might thus be seen that although CHP is expected to grow further, the explosiveness seems to be under control. There is a difference between industrial CHP and small-scale CHP, which is mainly used for commercial building (shops, hospitals, etc.). Industrial CHP is expected to be able to cover its costs and can up to a certain extent be scheduled with a flexible proportion of heat and power. Small-scale CHP is considered to be too inefficient to be profitable without subsidies. Since state-aid has been abolished in 1995, the growth in small-scale CHP is not expected to be large. SEP (SEP, 1996c, p. 17) warns that operational control limits may be reached at these levels. The point with CHP is that it runs most efficiently at a given proportion of heat-power production. Moreover, these (especially small-scale) CHP installations are hardly efficient if electricity production is considered alone. The relative efficiency stems from the by-product aspect as heat is produced. As a consequence, for most of this CHP capacity electricity is produced whenever heat is needed, and not necessarily when electricity is needed. Therefore, the central dispatcher has difficulties to schedule this capacity. SEP has now entered into an agreement with the larger (industrial) CHP capacities concerning the scheduling. Due to the joint-product aspect with heat, which is needed almost constantly in industrial use, the CHP capacity takes an almost base-load position in the dispatch. Average annual running times is roughly somewhat more than 6000 h, which corresponds to about 70% of total time. Total national consumption in 2006 is estimated at about 109,300 GWh (SEP, 1996c p. 9), which implies with, say, 5.5 GW CHP and 6000 running h annually, that some 30% of total demand will be produced by decentralized CHP capacity. Apart from inland capacity there is also import capacity, which is determined by the capacity of the

Reform of the electricity sector in the Netherlands

interconnectors. In practice, SEP more or less controls imports. SEP (SEP, 1996b, app. 5) reveals that simple addition of the border-crossing interconnectors amounts to 13,101 MVA 7. In 1995 approximately 13% of total consumption had been imported (SEP, 1996a p. 18) and SEP (SEP, 1996c, app. 4) shows that currently 3.5 GW capacity from abroad is under contract. These figures should illustrate that a dominant proportion of capacity is in the hands of the four centralized generators. Decentralized, especially, industrial CHP capacity and import capacity may be substantial, but cannot be expected to break the dominance. Very roughly, one might conclude that also in the near future at least 50% of total production must come from the four centralized generators. On the third stage, distribution companies have exclusive service areas in which all but the largest users are captive. The tariffs for the captive end-users are regulated, which means in practice that maximum tariffs are proposed by the sector and then (dis)approved by the Minister of Economic Affairs. As mentioned above, the distribution companies are not allowed to engage in large-scale fossil-fuel generation (Elektriciteitswet, 1989 art. 3). They may however engage in small-scale fossilfuel generation and generation with renewable energy sources. Furthermore, they are allowed, and in fact actively encouraged, to merge with other electricity distributors and distributors of other utilities, such as gas and cabletelevision. This horizontal integration has been a major development during the last five years. The number of distributors has declined from about 68 in 1986 to 27 in 1995 (SEP, 1996a p. 5) 8 and the electricity distributors have spread their wings over several other branches. One recent development is that a group of distributors has been granted a license for developing a second telecommunications network in the Netherlands. In effect, in a short period the distribution stage consisted no longer of a large number of relatively minor companies, but instead of only a few large multi-product enterprises (with a fringe of smaller ones). This development may be expected to have increased the relative bargaining power of the distributors as compared to the generators and SEP considerably. The electricity-act of 1989 outlines a quite complicated but nevertheless thoughtful system of internal payments. This system was thought both to minimize systemwide production costs and allow some competition. Without going into detail, the competition was introduced by allowing the distributors to choose their generator; the so-called 'horizontal shopping' (Elektriciteitswet, 1989 art. 13). However, the price differences between the generators, which were supposed to be the incentives for the distributors to shop around, could only be minor, due to the system of payments laid down in the act. These potential differ-

ences cover only a minor part of total costs, while the major part is pooled, resulting in a uniform tariff. In effect, the competitive potential of this measure is strongly doubted (MinEZ, 1995 p. 108). More importantly, the (price) structure set out in the electricity-act of 1989 for decentralized generation seemed to be self-destructive. First, the distributors were obligated to accept offers of independent, decentralized generation. The buy-back rate referred to the system's avoidable costs, which was based on a price internal to the system, based in turn on average costs of the centralized capacity. New decentralized capacity turned out to imply that this price and therefore the buy-back rate increased rather than decreased, attracting even more new investment 9. Second, combined-heat-and-power capacity (CHP) was exempted from the four generators' exclusionary rights over large-scale fossil-fuel generation (Elektriciteitswet, 1989 art. 1-1). This has been done because although CHP uses fossil fuel, it was nevertheless considered to be an environmental friendly technology, which should be promoted. The distributors invested quite heavily in CHP, which has been subsidized by government and given a favourable position, and can be seen as a means for the distributors to expose their tendency to expand. However, with the almost explosive growth of decentralized generation capacity, especially CHP, the licensed generators became increasingly aware of their stranded investment. This problem as well will be the explanation why the licensed generators took little part in the CHP-investment wave; in their investment decisions, they should take yet existing and not fully depreciated capital into consideration, which makes new investment far less attractive, especially so if there is excess capacity ~°. The independents need not take existing (centralized) capital into consideration; their incentives will mainly depend on contractual obligations, which may not coincide with the existing capacity H. Consequently, facing severe excess capacity, the licensed generators persuaded the distributors and the government to maintain the status quo for the time being and not to invest in new capacity. Meanwhile, a satisfactory solution had to be looked for. At first glance surprisingly, the distributors have agreed to delay profitable new investment, while one may wonder why they should care at all for excess capacity at the generators' side. The answer is simple: The (major) distributors own the production firms and have no incentive to lead the producers into destruction. Although the structure looks vertically disintegrated, in fact it is not. The distribution companies are owned by the provinces and municipalities. The generation companies are owned by the distributors, and SEP is owned by the generation firms. So, in the end, the entire structure seems vertically integrated and owned by the

119

Reform of the electricity sector in the Netherlands

lower-tier government. The government does not want to give up its control over the sector entirely, but retains its authority only at arms-length (Loozen-Meulendijks, 1990 p. XVI) ~2. However, the current status of the sector can almost be considered as privatized; the firms are set up as independent and commercial entities, of which the shares are in the hands of lower-tier government. Concluding, the threat of excess capacity is real and mainly induced by subsidies and an inconsistency in the electricity-act of 1989 itself. This most prominent inconsistency is recognized as such by the "Derde Energienota" (MinEZ, 1995 p. 107). Moreover, it seems that the shift in power towards the distributors practically forced the regulatory framework to break. At the time of the design of the electricity-act of 1989 the distributors were, if present at all, too small and insignificant to capture all the rents which, based on increased power, they might now be expected to capture. Within the framework of the electricity-act of 1989, SEP determines what happens in the sector, not the distributors. The "Derde Energienota" carefully notes that there seems to have been some tension in the sector, which apparently released the distributors from any responsibility concerning overall capacity (MinEZ, 1995 p. 107). One other, more idealistic reason for structural change may be the growing awareness that the original intention of promoting competition in the electricity sector may not have been very successful (MinEZ, 1995 p. 108). Foreign experience, particularly in the United Kingdom and Norway has shown that further reaching competition can work. This experience undoubtedly had its impact.

Outline of the governmental concept for a new structure

The "Derde Energienota" clearly defines three goals for the new reform, which however seem to be partly contradictory. Below, the proposed structure will be described and discussed in terms of these three goals. • First, the government is aware that the competitive potential in the electricity-act of 1989 has not been that successful and wishes to introduce more rigorous forms of competition into the sector with the new structure (MinEZ, 1995 p. 108). • Second, the government wishes to strengthen the Dutch electricity sector in anticipation of the competition of an open European internal electricity market. The wish for competition on a national level is somewhat counterbalanced by the fear of competition on a European level (MinEZ, 1995 p. 108 ft.). • Third, in the face of excess capacity with associated stranded-investment problems, the government wishes to induce more vertical cooperation between the 120

different vertical stages on investment issues (MinEZ, 1995 p. 107). More competition

More than before the sector will be characterized by vertical disintegration. First, an extra stage is distinguished and second, because entry be will free at some stages while not at others, a clear definition of the stages is indispensable. The extra stage will be created at the distribution level, with a clear distinction between the distribution network and distribution service. The former is the physical infrastructure. The latter consists of the buying and selling of electricity, design of contracts, metering, billing etc. The distribution service may be called supply. This distinction is a relatively new development and was first introduced in Chile and in the United Kingdom. The philosophy behind this distinction is that the infrastructure is commonly seen as a noncontestable natural monopoly, whereas supply allows for competition, both active and potential. It must be stressed, however, that these two stages are highly interrelated: Access to the network is an essential input to supply. The other stages, generation and transmission, will be vertically disintegrated. As a pleasant surprise, a subtle though essential distinction is made on the coordination level: Technical dispatch is explicitly distinguished from economic dispatch (MinEZ, 1996 p. 15). Although it is not entirely clear yet whether these tasks will be separated or integrated institutionally, the mere fact that they are considered different tasks is important. Explicitly distinguishing these two coordination tasks, at least in mind, is of importance for entry on the generation stage; this will be discussed more thoroughly in Section 4. The competitive elements will be introduced by free entry at both the generation stage (MinEZ, 1996 p. 16) and the supply stage (MinEZ, 1996 p. 7-9). For the generation stage, this implies that the artificial and problematic distinction between centralized and decentralized capacity more or less vanishes. Entrants will have the same status as incumbents ~3. New entry will be possible with free choice of scale and energy source. In effect, there is no guarantee or obligation to accept 'decentralized' generation as there is under the current structure. Instead, the entrants will have to offer contracts to suppliers and/or offer their production to a spot market. It is not clear yet how the trading is going to take place; it will be left to the sector to work out. It is anticipated that the compulsory pooling of generation capacity will be abolished, and consequently, economic dispatch will be voluntary (MinEZ, 1996 p. 17). On the supply stage, a distinction is made between socalled captive and non-captive customers. This distinction is made much in analogy to the United

Reform of the electricity sector in the Netherlands

Kingdom. Three groups of customers are foreseen. First, the group of large users, which are defined by an annual usage of over 10 million kWh. This group consists of about 350 customers and makes up for about 28% of the total market volume (in kWh) (MinEZ, 1996 p. 9). This group will be non-captive from the start and can be supplied by any firm. This will create competition between existing suppliers and induce new entry by what the proposal calls 'electricity traders' (MinEZ, 1996 p. 9). The second group is a more or less hybrid form. It is a group of approximately 56,150 customers with a demand volume of about 33% of the total market. The group is defined by a connection of more than 3"80A and an annual usage of less than 10 million kWh. Interestingly, the qualifiers for this group have a choice: They may irreversibly choose to be non-captive. This will make them free to choose their supplier, but make them lose the right to be supplied and to be protected by the regulator (in particular, regulated tariffs). There are provisions for exercising this right of choice and ten years after the implementation of the new law, the entire group will be made non-captive (MinEZ, 1996 p. 9). The third group consists of about 6.7 million small end-users, with about 39% of total market demand. They are defined by a connection of less than 3"80A. It is not anticipated currently that this group will be non-captive at all, unless a user explicitly chooses to, which will be allowed 10 yr after implementation of the law. Consequently, for at least ten years the currently incumbent suppliers will be licensed monopolists on the domestic supply market ~4. The tariffs for captive customers will be regulated. The provisions in the proposed law are subtle in this respect. By giving all captives the ultimate choice to free themselves if they wish to, the remaining monopoly power is limited by the development in (the costs of) metering. Effectively, thus, the market will be free, entry will be allowed, but the government recognizes that for sufficiently small end-users the threat of entry may fail due to the high switching costs. As a response, the incumbent suppliers will be regulated for these customers ~5. In order to stress the distinction of the stages and to provide a symmetrical framework for all (future) competitors, the entire network is separated. That is, the transmission network as well as the distribution networks will be structurally separated from the other stages (MinEZ, 1996 p. 12). This is relatively innovative, both compared to the "Derde Energienota", where this had not yet been foreseen, and compared to other countries. Commonly, it is considered that distribution networks and supply should not be structurally separated. Apparently, the Dutch sector has a different opinion. There may be economies foregone by the structural separation, but it is bound to have a positive impact on entry and competition in the supply stage, and will most certainly

ease the regulator's task. Of course, access must be nondiscriminatory and access charges will be regulated (MinEZ, 1996 p. 12). Non-discriminatory access is more likely under structural separation than under an integrated structure with third party access (TPA). It is expected that the transmission stage will be operated by one national institution, while there will be several regional distribution networks. Strengthening the Dutch electricity sector

The four currently centralized licensed generators are said to be financially weak (MinEZ, 1995 p. 121). Especially, solvency is said to be low and their respective scale small compared to firms in neighbouring countries. Moreover, currently they are faced with substantial stranded investment which may be next to worthless. In effect, the sector and the government fear a rather poor competitive performance of the incumbents towards European competitors, and moreover, fear hostile takeovers (MinEZ, 1995 p. 121). Furthermore, the willingness to open the domestic market to European competitors--which is present in principle--seems to have declined somewhat due to a lack of reciprocity. The developments on the internal European electricity market might be called rather slow. After a series of proposals and severe disagreement, the 15 EU members finally reached an agreement on 20 June 1996 (see e.g. Financial Times, 21/06/96, p. 2). This agreement foresees a restrictive form of competition for the largest end-users, which nevertheless covers about 22% of the market in volume tr. Two systems are allowed to exist simultaneously. First, negotiated third party access and second a single buyer system. To protect the TPA systems for non-reciprocity from the single buyer systems, the agreement includes the allowance of an import prohibition in case of non-reciprocity. This principle has been included in the Dutch white paper; explicitly, imports can be prohibited by the Minister of Economic Affairs if the exporting country does not have an equally competitive provision (MinEZ, 1996 p. 25). For both these reasons, the government seems to have agreed to the sector's wish to create a 'national champion'. The proposal suggests that the four incumbent firms will merge into one generation firm with SEP (MinEZ, 1996 p. 23). Consequently, some 77% of the total generation capacity will be in one hand only, which from hereof will be called the 'dominant (generation) firm'. For a clear understanding, it must be stressed that SEP will have to divest the transmission network, which as mentioned, is to be structurally separated. Furthermore, for a transitional period, the dominant generation firm is not allowed to be active on the supply stage (MinEZ, 1996 p. 23). As a matter of consequence, for the same period, the incumbent suppliers are not allowed to participate in large-scale generation. The

121

Reform of the electricity sector in the Netherlands proposal says that the dominant generation firm will not be regulated; it will simply be one of the generators on a stage with free entry (MinEZ, 1996 p. 23). A more thorough discussion of the intention to create a national champion follows in Section 4. Vertical cooperation Yet another puzzling aspect of the proposal is the goal of inducing more vertical cooperation. Clearly this wish has been triggered by the threatening excess capacity. This is supposed to be achieved by maintaining (most of) the current ownership structures, which has two aspects. The first aspect concerns the internal ownership structure. The proposal sees "insufficient reasons to require that the ownership structures of the networks are changed" (MinEZ, 1996 p. 12; translation by author G.B.) 17. Consequently, the dominant generation firm will be the owner of the transmission grid, while the licensed suppliers will be the owners of the distribution networks. Moreover, the dominant firm will be owned in majority by the incumbent suppliers (MinEZ, 1996 p. 23). In effect, the incumbent, licensed suppliers will collectively own the entire sector. The proposal is quite optimistic about what it calls 'functional specialization' between the dominant generation firm and its shareholders (MinEZ, 1996 p. 23). It expects the regulator to forestall "undesirable conflicts of interest and/or cross-subsidization" between the networks and the other stages (MinEZ, 1996 p. 12). This is of course questionable. The second aspect concerns the external ownership. Whereas the "Derde Energienota" mentions the option for privatization (MinEZ, 1995 p. 99), this option has been skipped entirely in the white paper. At the moment there is no discussion about whether the provinces and municipalities will remain to be the shareholders of the sector j8. As mentioned above, the current status already is the final stage before full privatization, and moreover, it may be expected that competition by new entry will further increase the pressure on the state-owned firms. Given this status, the question whether the shares should be in state-hands or private hands seems to be a matter of taste. The main problem seems to be the interrelated ownership structure, which seems to be internally inconsistent. Clearly, if the structure is such that it induces vertical cooperation, then by the same token, it casts severe doubts on the plans for structural separation. The dominant generation firm may be expected to attempt to abuse the transmission network to foreclose the generation market, and in the same way the suppliers may try to foreclose the supply market with the distribution networks. Moreover, through the collective ownership of the generation firm, the suppliers may avoid too harsh competition on the supply market, depending strongly on the number of shareholders.

122

Given that privatization is not going to take place and thus given that the provinces and municipalities will keep the shares of the industry, it may be an idea to break up this interrelated structure. As an alternative, one might consider to leave the shares of the different stages directly to the provinces (and municipalities), instead of indirectly through the interrelated structure. It is of utmost importance to be very clear on the ownership structures between the monopoly parts and the competitive parts. The relevant question seems to be: Is it necessary at all to promote vertical cooperation? The stranded-investment problem is mainly an inheritance of the past and can be dealt with in other ways (further see Section 4.1). In a proper setting, there is a priori no reason to assume that market incentives could not handle the investment problem. Evaluation

Two issues seem to be of special interest. First, the dominant generation firm and the specific form of the dispatch and trading. Second, the regulation of the network access charges and the tariffs for captive customers. Entry and competition in generation As mentioned above, the proposal suggests the merger of the four main generators into one dominant generation firm, which will subsequently own some 77% of total production capacity. Furthermore, by the interrelated ownership structure it is questionable whether the generation capacity of the distributors can be seen as independent and competitive. The fringe will consist of imports (which is restricted by the capacity of the interconnectors), co-generators and independents. The obvious way to characterize this market structure is as a dominant firm with a competitive fringe, of which the adverse (static) welfare effects are well known. Moreover, since generation capacity is highly sunk, one would not expect a contestable market. However, this may be modified. The proposal suggests that the generation firms make contracts for their capacity and their subsequent production. As Newbery (1995) points out with reference to the generation market in the UK, the contracts themselves can make the market contestable to a certain extent. If an entrant can sign a (long-term) contract with a supplier, price-cutting by the dominant firm will not harm the entrant. If a supplier needs a new contract because of new demand, it can organize a tendering among incumbent and potential generators. No matter how dominant the dominant firm is, it will always be set equal to the others in the tendering for new capacity. After the price and probably other provisions are laid down in the contract, the dominant firm cannot abuse its dominant position. This seems to be applicable for new

Reform of the electricity sector in the Netherlands

capacity rather than for already existing contracted capacity. Moreover, the possibilities for new entry on the generation stage seem to depend on the incentives of the suppliers to accept these contracts and thereby accept competition by the entrants towards the incumbent firm. Clearly, the interrelated ownership structure is crucial in determining these incentives. Alternatively, the entrant could enter at two stages simultaneously. This may be difficult if the incumbent suppliers can foreclose the market by means of the distribution networks, or if the generation firm can abuse the transmission network. Again, the interrelated ownership structure is crucial in setting the incentives. The modification is not to say that the creation of the dominant firm is no problem; it only says that it may not be as bad as it seems. However, not creating a dominant firm seems to be superior from a competitive point of view. A plausible explanation for the creation of the dominant generation firm is that it needs monopoly-rents to recover the stranded investment associated with the excess capacity. However, this solution to this problem destroys a competitive potential unnecessarily. The major cost advantages are to be made at the generation stage, for which competition seems to be an appropriate means. The costs of stranded investment can be recovered on the remaining monopolistic stages; the distribution networks or the captive supply part. The monopoly parts may be allowed an excess profit to compensate the generation stage for stranded investment ~9. For the consumers it is irrelevant whether the mark-up is paid at the generation stage or another stage, because they pay the final price and do not notice the composition. In this way, the costs of stranded investment can be recovered and, simultaneously, competition can be introduced at the generation stage. In conclusion, it seems to be unnecessary and harmful to have a dominant firm on the generation stage; instead the natural option would be to just retain four generation companies. It is well known and common practice in electricity, that significant production costs can be saved if the generation units are centrally coordinated. Expositions of this principle are e.g. power pools in the United States, the electricity pool in England and Wales and the socalled Landelijke Economische Optimalisatie 2° (LEO) in the Netherlands. The proposal suggests that this LEOprogram continues when it states that "[p]roduction units of independent producers will have to be taken up in this LEO without discrimination: In the new structure it is left to the market parties to work this out within the legal possibilities ''2~ (MinEZ, 1996 p. 15; translation by author G.B.). It is not clear yet who will undertake the economic dispatch, although the network operator seems to be a likely candidate. Simultaneously, the proposal foresees that the compulsory pooling of generation will be

abolished (MinEZ, 1996 p. 17). Instead, new rules for the dispatch have to be worked out by the sector. A referee has suggested that the tradition of 'negotiated regulation' should ensure that these rules are fair to all parties. I fear, however, that the mentioned 'negotiated regulation' will be biased towards the interests of the incumbent parties, at the expense of future entrants, which cannot yet participate in these negotiations. If the gains to be made by central dispatch are indeed significant then the dominant firm might not even have an incentive to engage in the central dispatch 22. Reverse the argument; by not engaging in the central dispatch, the dominant firm would effectively exclude the fringe from central dispatch. Suppose thus there are two separate (self)dispatches; one of the dominant firm and one of the rest. Clearly, other things being equal, the dominant firm with about 77% of capacity will have the lower average costs and will therefore be able to offer the better contract 23. In general, such strategic behaviour may be compared to what is called raising rivals' costs (see Salop and Scheffman, 1983). Not only would this strategy hinder entry, it may also cause productive inefficiency because the dispatch could have been better. This effect is strengthened if it is realized that for the ex-ante and realtime dispatch so-called priority rules have to be maintained to determine the priority order of generation in case of conflicting schedules or emergencies. The dominant firm could create an advantage for itself if it is able to get the highest priority for its own generation units. This will depend to a large extent on the incentives of the dispatching institution and on initial rules, which 'have to be worked out by the sector'. To the extent that produced volumes do not fit the contracts, the firms will have to clear the differences among each other (MinEZ, 1996 p. 17). It is likely that for this purpose a spot market and spot price will be established. It is quite likely that the dominant firm will be able to manipulate the spot market and -price such that the cleating is biased in its favour. It may be noted that if alternatively the pooling would be compulsory and there would be a spot price for the clearing, the entire system would be very similar to the system in the United Kingdom 24. As a comparison, in the United Kingdom there are still worries about the market power of the dominant duopoly (PowerGen and National Power) which has currently a market share of about 62% in capacity (Newbery, 1995; Green, 1996; MMC, 1996). As an overall lesson from the United Kingdom, the dominant firm in the Netherlands may be expected to have significant market power, at least until new entry has reduced its dominance. It is of crucial importance to design the dispatch such that new entrants have equal access to the production and can offer attractive contracts. Since, however, this is not in the interest of the incumbent, this should not be left to the sector without

123

Reform of the electricity sector in the Netherlands

further control or consent. In case this is not clear at first sight, a comparison with the airline industry might be illustrative. New airline entrants will have to have slots for landing rights in order to be able to compete the incumbent(s); if the incumbent can control the allocation of slots, it effectively controls entry and can exploit its dominant position. To a certain extent, the dispatch of electricity can be seen as the allocation of slots. Regulation

The proposal suggests that the networks will be structurally separated from the supply. In fact, the network operators will not be allowed to be active on any other competitive field (MinEZ, 1996 p. 32) 25. This is related to a discussion about structural separation versus what is called accounting separation as a regulatory device; this discussion applies particularly to telecommunications (see e.g. Cave and Martin, 1994). Briefly, accounting separation allows the monopolistic part to be integrated with the competitive part, but both parts have separate bookkeeping. Moreover, this scheme requires that, (1) the monopolistic part is regulated, (2) third party access to the network is guaranteed and (3) access charges must be non-discriminatory; the latter means that the network operator should charge its own supply department the same as it charges third parties. Under structural separation, by lack of incentive, the separated network operator can be expected to behave in a non-discriminatory manner. The trade-off may be obvious. Accounting separation will save any economies of vertical integration, while on the other hand, it will induce higher regulatory costs or, to the extent that regulation is imperfect, induce market foreclosure in potentially competitive markets. Applied to the specific situation described by the proposal, it is not clear whether the situation should be called accounting separation or rather structural separation. As explained in Section 3, the ownership structure will be interrelated, although the proposal suggests structural separation 26. If structural separation cannot be expected practically, access charges should be nondiscriminatory in the sense defined above. This, however, is not explicitly called for in the proposal, although it seems to be implicitly present in the background. The point to stress is that the proper regulatory framework depends crucially on whether the situation is structurally separated or not. It is important to be explicit about this and adjust regulation if necessary. The tariffs for the captive customers will be regulated while the tariffs for the non-captives will be free. Moreover, the profits of the network operators will be regulated (MinEZ, 1996 p. 14). To simplify the argument to be made below, it will now simply be assumed that the distribution network is indeed structurally separated and perfectly regulated. This allows to concentrate on the

124

downstream service market with its characterization of captive and non-captive customers. It is important to stress that the discussion on structural separation or not, does not apply on this horizontal level. The regulation of the captive tariffs are maximum tariffs set by the regulator (MinEZ, 1996 p. 11). The interesting part is where the proposal says: "[d]ue to a tight maximum there are restricted profits on the supply to captive customers, which makes cross-subsidies from the monopoly-part (supply to captive customers) to the market-activities hardly or not possible ''~7 (MinEZ, 1996 p. 12; translation by author G.B.; round brackets in original). Of course, it is always possible to cross-subsidize if it is not controlled, but in the short run it is useless. Since the tariffs on the monopoly part are set, every attempt to make an extra profit by shifting costs from one market to the other will be compensated immediately by a loss on the other market. This indifference would not be the case under profit (or cost-plus) regulation of the monopoly market. The firm would attempt to shift costs from the competitive market to the monopoly market; thereby it can make a profit on the competitive market without having to face entry, while still make zero profit on the regulated market, increasing overall profits. Thus, the solution of setting maximum tariffs looks quite sensible. However, there will still be a regulatory problem here. Then, how exactly are these tariffs going to be set? The regulator will have to have some reference to the underlying costs. Realizing this, and realizing the indifference in the short run, the finns will have an incentive to shift costs to the monopoly part in order to convince the regulator that in the next round of negotiations the maximum tariff should be higher. Effectively, the maximum-tariffs regulation (in contrast to profit regulation) makes an ex-ante bargaining problem from an ex-post incentive problem with more or less the same outcome. The cross-subsidization problem can still be a problem and cannot be overlooked. To conclude, if the firms will have profit maximization as their ultimate goals, then, within the new framework, regulation will be a task of utmost importance and the regulator's task will be a difficult one. However, in order for the regulator not to be 'captured', the law should already prescribe a proper regulatory framework, which it does not in the white paper. Conclusions This paper has attempted to describe and assess the proposal for a new reform of the electricity sector in the Netherlands, which has been presented by the Department of Economic Affairs in July 1996. It has been argued that the desire for a new structural reform has been induced by the threat of excess capacity, a shift in power from the generators to the distributors and the

Reform of the electricity sector in the Netherlands

wish for more competition. The proposal can be characterized by three major aspects. First, competition will be promoted by free entry in generation and supply; the latter is the service to endusers. Moreover, the entire network will be (structurally) separated from the other stages, which should secure non-discriminatory access to the infrastructure. Second, to be prepared for European competition, a dominant generation firm will be created with approximately 77% of total capacity. Third, in order to strengthen vertical cooperation particularly in investment issues, the ownership structures will (still) be interrelated. In particular, the networks will be owned by the generation firm and the incumbent suppliers, and the incumbent suppliers will collectively own the dominant generation firm, while being owned themselves by lower-tier government. Privatization is not an issue in the proposal. The evaluation has concentrated on three issues. First, the interrelated ownership structure has been questioned, recommending that breaking up the structure might be preferable. The shares of the different stages might be in the hands of the governmental shareholders directly, rather than through a shareholding-chain. Second, it has been argued that the merger into the dominant generation firm is unnecessary and harmful. A valuable opportunity to create competitive pressure in the stage with the largest cost-saving potential may be foregone to a large extent. In contrast, retaining four separate firms will be preferable. A monopolistic mark-up to recover the costs of stranded investment can be charged further down the stream in e.g. the distribution. It has been stressed furthermore, that the design of the rules for dispatch is of utmost importance for new entry. This design should be carefully monitored and not simply be left for the sector to work out. Third, it has been argued that remaining regulatory problems may be somewhat underestimated in the proposal. In particular, the regulatory framework to be chosen depends on the effects of the interrelated ownership structure, which however is not clear. Moreover, it has been stressed that a possible cross-subsidization incentive cannot be defined away by setting maximum tariffs rather than profit-regulation. This merely makes an ex-ante-bargaining problem from an ex-post-incentive problem. Parts of the views in this paper rely on interviews with executives from the Dutch electricity sector, to whom I am much obliged. I am grateful to R. Green, G, Knieps, D. Newbery, H.J. Weiss and an anonymous referee for useful comments. Of course, the views expressed are my own and all errors remain my responsibility.

und Perspektiven. Zeitschrift fiir Energiewirtschaft 1/91, 27-36. Brunekreeft, G. (1996) Coordination and competition in the electricity pool of England and Wales, forthcoming Nomos, Baden-Baden. Cave, M. and Martin, I. (1994) The costs and benefits of accounting separation. Telecommunications Policy 18(1), 12-20. Elektriciteitswet (1989 November 16) Staatsblad 535. Financial Times (21/06/96) EU in accord with electricity, p. 2. Green, R. J. (1991) Reshaping the CEGB: electricity privatization in the UK, Utilities Policy, April, pp. 245-254. Green, R. J. (1996) Increasing competition in the British electricity spot market. Journal of Industrial Economics 44(2), 205-216. Hope, E., Rud, L. and Singh, B. (1993) M~irkte fiir Elektrizit~it: die 6konomische Reform des norwegischen Elektrizit~itssektors. Zeitschrift for Energiewirtschaft, March, pp. 29-46. Joskow, E L. and Schmalensee, R. (1983) Markets for power. MIT Press, London. Kaijser, A. and Hedin, M. (1995) Nordic energy systems: historical perspectives and current issues. SHP, Canton, Mass. Ktinneke, R. W. (1991) Op armlengte van de overheid; een theoretisch en empirisch onderzoek naar de effecten van verzelfstandiging op de efficifintie van openbare nutsbedrijven. Universiteit Twente, Enschede. Loozen-Meulendijks, C. H. M. A. (ed.) (1990) Elektriciteitswet 1989. Tjeenks-Willink, Zwolle. MinEZ (1995) Derde Energienota, Ministerie van Economische Zaken, Den Haag. MinEZ (1996) Stroomlijnen naar een markt voor elektriciteit; Opzet voor een nieuwe Elektriciteitswet, Ministerie van Economische Zaken, Den Haag. MMC (1996, April) National Power PLC and Southern Electric plc; A report on the proposed merger. Monopolies and Mergers Commission, HSMO, London. Newbery, D. M. (1995) Power markets and market power. Energy Journal 16(3), 39--66. Newbery, D. M. (1996) Privatization and regulation of public utilities, Presidential Address to the European Economic Association Eleventh Annual Congress in Istanbul, 22 August 1996. OFFER (1995, November) The competitive electricity market from 1998; customer protection, competition and regulation, OFFER, Birmingham. Salop, S. C. and Scheffman, D. T. (1983) Raising rivals costs. AER Papers and Proceedings 73(2), 267-27 I. SEP (1996a) Elektriciteit in Nederland 1995, SEP and EnergieNed, Arnhem. SEP (1996b) Electricity Plan 1997-2006, SEE Arnhem. SEP (1996c) Notes to Electricity Plan 1997-2006, SEE Amhem. Summerton, J. and Bradshaw, T. K. (1991) Towards a dispersed electrical system; challenges to the grid. Energy Policy 19(1 ), 24-34.

References Bartels, R., Cohen, R. and Hoehn, T. (1991) Das neue Elektrizit~itssystem in Grol3britannien: Erste Erfahrungen

~English (translation by author G.B.): "Streamlines to a market for electricity; Outline for a new electricity law". References in the text to this document will be MinEZ, 1996. MinEZ stands for "Ministerie van

125

Reform o f the electricity sector in the Netherlands Economische Zaken", which is the Dutch Department of Economic Affairs. 2English (translation by author G.B.) "Third Energy-memorandum". References in the text to this document will be MinEZ, 1995. 3Extensive use has been made of Loozen-Meulendijks (1990) which provides the act with useful comments and explanations. 4For a more detailed description of the UK sector, the reader may be referred to e.g. Bartels et al. (1991), Brunekreeft (1996, Chs 7, 9), Green (1991) and Newbery (1995, 1996). For the Nordic countries good references are Hope et al. (1993) and Kaijser and Hedin (1995). 5The solution to the economic coordination problem may be seen as a subset of the solutions to the technical coordination problem. In general, there will be many production schedules which fulfil the technical constraints of the system, most of which, however, will not be cost-minimizing. ~'English (translation by author G.B.): "Cooperating Electricity Production companies". 7Ahhough Power (W) is Voltage (V) times Current (A), here unfortunately, this figure cannot be readily interpreted in terms of MW; MVA is apparent capacity. Depending on what is called cos ~p, real capacity (in MW) may be substantially lower. The interested reader may be referred to technical books on electricity. SMoreover, to modify this picture, of these 27 a few are relatively large, whereas there is a large fringe of small distributors. '~This is quite similar to experiences in the USA with decentralized capacity under PURPA (see e.g. Summerton and Bradshaw, 1991). "~Alternatively, the electricity-act of 1989 prescribes the licensed generators plus SEP to set up every two years a so-called electricity plan in which the centralized investment for the coming ten years is laid down. The electricity plans had not perceived the rather substantial growth in decentralized CHP and moreover apparently while making this plan the generators had underestimated the efficiency development of CHP. I would like to thank the referee for pointing this out. "This could well explain why new investment in the Netherlands had mainly been CHP, while in the United Kingdom the investment wave concentrated on improved CCGT. The electricity-act of 1989 exempts CHP capacity, but leaves CCGT to the exclusionary right of the licensed generators. The latter, apparently, had no incentive to invest in new capacity whatsoever. r2See for a more thorough discussion KiJnneke (1991). ~3Except for very small entrants with renewable energy sources which the government thinks should be promoted. ~4The main reason behind this distinction are the high costs of metering equipment required for full implementation of competition in supply. It is then necessary to install time-of-use meters in order to attribute fluctuating variable costs of electricity generation. Currently, the cost of required metering equipment is too high for small consumers (MinEZ, 1995 p. 85). In the United Kingdom where according to plan in 1998 the group of smallest end-users will be made non-captive, this problem is recognized as well. Instead, profiles will be used as an approximation

126

of consumers' time-of-day usage (OFFER, 1995 November, p. 26). ~SMind that these switching costs only concern the step from captive to non-captive. There might yet be other switching costs in choosing one supplier over another, being non-captive. '6After six years this will be further opened to about 32% of the market volume. ~7Original: ".. onvoldoende redenen om te bevorderen dat de eigendomsverhoudingen van de netten worden gewijzigd". ~SThe "EnergieNota" (MinEZ, 1995 p. 101) states in this respect that it should be secured that liberalization does not create 'private monopolies'. In a press release from November 11, 1996 the Minister of Economic Affairs stressed that a decision on privatization will be postponed until the market functions properly. Moreover, the privatization question is primarily the subject of the shareholders (i.e. the provinces and municipalities), not of the central government (see also MinEZ, 1995 p. 100). ~gGiven the interrelated ownership structure, transfers back to the generators seem to be unnecessary. 2°English: National Economic Optimization. 2~Original: "Productie-eenheden van onafhankelijke producenten zullen in deze LEO non-discriminatoir moeten worden ingepast: in het nieuwe stelsel is het aan de marktpartijen om dit in te vullen binnen de juridiscbe mogelijkheden". 22As a reminder, this all concerns economic dispatch: There is always central technical dispatch in the background. '-3The argument will weaken somewhat if one considers that entry is possible at base load, mid merit and peak load. These dispatching problems will hardly play a role at the base-load level. 24From a press release from the Department of Economic Affairs from November 11 1996, it is suggested that voluntary pooling will be accompanied with an electricity-spot-market. This pushes the system more to the model of Nordic countries. However, there is an important difference. In the Nordic countries central dispatch does not play such an important role because the bulk of electricity is produced with hydro-electric power. Therefore, adverse strategic effects of voluntary pooling, as described above in the text, may be expected to be less severe in the Nordic countries. 25They may however own other monopolistic (and thus regulated) networks, e.g. a gas network. 26To be precise and then leave it to the reader, the proposal says: "organizational, legal and financial separation" (MinEZ, 1996 p. 12; translation by author G.B.). Since, however, the ownership is not strictly separated a strong case can be made against structural separation; the separation conditions mentioned above might then be seen as an attempt--however incomplete--to implement accounting separation. 27Original: "Door een krap maximum ontstaan er beperkte winsten op de levering aan gebonden klanten waardoor kruissubsidie van het monopoliedeel (levering aan gebonden klanten) naar de marktactiviteiten niet of nauwelijks mogelijk is."