Balancing power and the unintended governance structure in the Dutch electricity industry[1]
Abstract
Since 1996, the European Commission and the national governments in the EU have aimed for a market to balance the supply and demand for electricity in real time. We hypothesize why this politically favored market for balancing power did not materialize in the Netherlands. On the basis of a survey among the energy firms responsible for the supply of balancing power, we demonstrate that the balancing transaction is more efficiently governed by the existing hybrid structure.
Keywords: Governance, transactions, regulation, balancing, electricity
JEL codes: D23, L94, Q48
1. Introduction
The Member States of the European Union have been liberalizing their electricity industries for more than a decade. In 1996, 2003 and 2009, the European Parliament and the European Council issued directives with common rules for the Member States on the creation of a European electricity market (EC, 1996, 2003, 2009). One of the main requirements of these directives is the vertical unbundling of the electricity industries, which means that the electricity networks with natural monopoly characteristics have to be separated from the production and retail of electricity. This vertical unbundling should enable the introduction of competition in the latter two activities.
The vertical unbundling was described by Joskow (1996: 345) as the “standard neoclassical public policy prescription” for reforming these industries, and he observed that “it either assumes that there are no economies of vertical integration or that the efficiencies associated with vertical integration can be replicated with simple access rules” (Joskow, 1996: 346-347). Many policymakers have not considered these efficiencies of vertical integration, but have instead “been surprised by how difficult it has been to create wholesale electricity markets” (Joskow, 2000: 52, quoted in Williamson, 2002: 187). In 2007, more than ten years after the first directive, the European Commission concluded in its Energy Sector Competition Inquiry that the EU wholesale electricity markets are not yet functioning properly (EC, 2007).
In this article, we explain why the market, as a type of governance structure, has been so difficult to create in the electricity industries. We focus on the difficulties with creating a market for the balancing of electricity supply and demand in real time. One of the particular characteristics of electricity is that it cannot efficiently be stored and that consequently the demand for and the supply of electricity need to be balanced every second of the day. The operators of the electricity network balance electricity supply and demand for the entire electricity system, and they call upon the producers of electricity to increase or decrease their production to resolve an imbalance on the network.An important transaction for the balancing of electricity supply and demand is the supply of this so-called balancing power by the electricity producers to the network operators. Both the 2003 and 2009 European electricity directives prescribe that a market should be created for the balancing of electricity supply and demand. The directives state that “cost-reflective balancing mechanisms are necessary” and that “this should be achieved through the setting up of transparent market-based mechanisms for the supply and purchase of electricity needed in the framework of balancing requirements” (EC, 2003: 38; EC, 2009: 59).
This article demonstrates that a market governance structure for balancing has not emerged in the Dutch electricity industry, even though this industry has implemented the European electricity directives into the national laws and regulations. Why this market has not emergedwill be explainedon the basis of transaction cost economics, in which the comparative efficiency of a governance structure depends on the proper alignment of the structure with the attributes of the transaction.In this article, the main explanation for the existence of a particular governance structure is found in the ex post inefficiencies and efficiencies that are the result of the regulatory interventions. Initially, the imposed market governance structure created a misalignment with the existing balancing transaction. The required extensive investments in specific assets and the market governance structure in place at that time reduced the energy firms’ willingness to supply balancing power. Later, the national regulator imposed a hybrid structure, thereby providing a more efficient safeguard for the incomplete contracts between the network operator and the energy firms.
The analysis of incomplete contracts and ex post (mis)alignments make the transaction cost economics framework more effective in addressing the issues of this article than alternative theoretical perspectives, such as the property right theory perspective, stressing ex ante investments and costless renegotiations ex post, or the contract theory perspective, focusing on complete contracts and asymmetric information.
Other studies on the electricity sector, in particular from a transaction cost economics perspective, have also been concerned with the governance structure, but more of the entire sector, and less with thebalancing mechanism (e.g. Joskow, 1996; Glachant, 2002). Those studies concerned with the balancing mechanism, in particular from a price theoretic perspective, have addressed price disparities and arbitrage, and less the governance issues (e.g. Bessembinder and Lemmon, 2002; Hortaçsu and Puller, 2008). This paper focuses in particular on the governance structure of balancing, because the continuing European attempts at unbundling and at creating a balancing market warrant attention to the governance issues. In addition, the balancing of electricity supply and demand, as a transaction, has been underemphasised, yet it is a transaction that is vital for a proper functioning of the electricity industry and for the safety and security of electricity supply. Hence, we aim for an explanation of the governance form with the attributes of the balancing transaction.
The Dutch electricity industry is an interesting case as the governance structure for the Dutch balancing transaction has been designed differently from other governance structures for balancing in Europe (Glachant and Saguan, 2007). In this design, the predictability of the imbalance price has deliberately been reduced in order to prevent energy firms to profit from creating an imbalance. This also makes the study of arbitrage conditions between forward and balancing prices in the Dutch industry less pressing, as Boogert and Dupont (2005) have already demonstrated. It does set the Dutch case apart, as its design of the balancing mechanism immediately acts, in transaction cost economics terminology, on the incentive intensity of the governance structure. This offers an opportunity to explicitly focuson the alignment of the governance structure with the attributes of the balancing transaction.
Although some of the features of the Dutch balancing mechanism make it stand out, other issues arising from the EC directives are shared with other European industries. The analysis of the British electricity industry by Newbery (2004), illustrates the similarities of governance changes from a pooling system to trading arrangements, with increasing governance costs. Likewise Glachant and Saguan (2007) discuss the institutional framework of balancing in France, Belgium and the Netherlands, as they are all confronted with the same European directives on the creation of a market.
We have collected data on the attributes of the balancing transaction with a survey among the Dutchenergy firmsthat are responsible for the supply of balancing power to the network operator. The survey demonstrates that the existing hybrid governance structure for balancing in the Dutch industry is comparatively efficient, and it explains why a balancing market has not emerged.
The following section presents the background of balancing in the Dutch electricity industry. Section three discusses the literature on the balancing of electricity supply and demand. In section four, we apply the transaction cost economics framework to the case of balancing in the Dutch electricity industry, and in particular, we conceptualize the attributes of the balancing transaction and those of the governance structure. We also formulate propositions to test our claims on the efficiency of the governance structure for the balancing transaction. In section five, we discuss the details of data collection and the type of survey that was distributed among the energy firms. Section six describes the results for the present governance structure and for the balancing transactions. In the final section, we conclude that the Dutch regulatory interventions to safeguard the security of energy supply, and the asset specificity and behavioural uncertainty of the balancing transactions have prevented a market for balancing power to emerge, and why they do explain the efficiency of the existing hybrid governance structure. We also draw some implications from this result.
2. Background
The value chain of electricity industries consists of at least four segments, and includes the production, transmission, distribution and retail of electricity. Electricity is energy that is produced with other energy sources, such as fossil fuels, nuclear power or wind energy, and production is the first step in the supply of electricity to consumers. Transmission refers to the transportation of electricity along the high-voltage electricity network, and distribution to the transportation of electricity along the low-voltage lines. The electricity retailers, that market and sell electricity to the consumers, are located at the end of the value chain.
One of the distinguishing characteristics of electricity industries is that electricity cannot efficiently be stored, or in other words, the supply and demand for electricity need to be in balance every second ofthe day. This feature of the electricity industry has since the beginning of the commercial production and consumption of electricity, at the end of the 19th century, had a determining impact on the structure and organization of the industry. A close coordination between the operators of the electricity network and the producers of electricity has always been required to balance supply and demand, and thus to ensure a safe and reliable supply of electricity to consumers. Over time, the type of coordination for the balancing of electricity supply and demand has changed, ranging from vertically integrated hierarchies to more de-integrated forms of organization, as driven by the imposed liberalization of the industries.
2.1 Dutch electricity balancing before liberalization
Before the liberalization of the Dutch electricity industry, balancing was organized through a tightly coordinated pooling system within a vertically integrated industry. The pooling system consisted of the four large electricity producers of the Dutch industry and an organization in which these producers cooperated, referred to as the SEP (Samenwerkende Elektriciteitsproducenten). The SEP operated the transmission network, purchased fuel on behalf of the producers, coordinated decisions on the location of new production plants, imported and exported electricity, and dispatched the electricity system (Cross, 1996). It pooled all the electricity of the producers and sold it for a uniform tariff to the electricity distributors. The SEP balanced electricity supply and demand for the entire Dutch electricity industry, by monitoring the amount of electricity that was taken out of the network by the consumers, and by ordering the producers to increase or decrease their production in order to balance supply and demand. The owners of the SEP were the cooperating electricity producers. Since the Dutch provincial authorities owned the electricity firms that both produced and distributed electricity, these provincial authorities also owned the SEP. The provincial authorities therefore vertically integrated the production, transmission and distribution of electricity. This governance structure (i.e. the vertical integration and pooling system) characterized the Dutch industry until the late 1980s (Arentsen et al., 1996; Van Damme, 2005). The vertical integration of the electricity industry was not a Dutch peculiarity. Many European electricity industries adopted a vertically integrated structure (Green, 2006; Hunt, 2002).
2.2 EU Directives and Dutch laws on liberalization and balancing
In the last few decades, the European Commission and national governments in the EU have focused their energy policies almost exclusively on the introduction of competition into the European electricity industries (Eising, 2002: 92). To attain the goal of creating one European competitive electricity market, the European Parliament and Council issued three electricity directives, in 1996, 2003, and 2009, on common rules for electricity production, transmission, distribution and retail. These directives prescribe the vertical unbundling of transmission and distribution from the integrated electricity firms, to enable the introduction of competition into the production and retail of electricity. By implication, the European electricity directives influence the governance structures in the liberalizing electricity industries; they prohibit the vertically integrated hierarchies and promote the emergence of market forms of governance. The 2003 and 2009 directives also stipulate rules for the balancing of electricity supply and demand. They state that “non-discriminatory and cost-reflective balancing should be achieved through the setting up of a transparent market-based mechanism for the supply and purchase of electricity needed in the framework of balancing requirements” (EC, 2003; 2009). The directives therefore also prescribe a governance change from the vertically integrated hierarchy to a market for the balancing transactions. The reasons for developing these European electricity directives can be found in the EU internal market program.
EU internal market program
The liberalization of the European electricity industries is driven, at the EU level, by the Internal Market Program (Eising, 2002: 92). In 1958, the Treaty of Rome laid down the goal of creating a common market and aimed at establishing the free movement of goods, services, labour and capital. Although at the end of the 1960s the impetus towards an effective implementation of the four freedoms lost momentum, Europe’s weakening competitiveness and rising unemployment from the mid-1970s strengthened awareness that the Community could gain from further market integration (Hoeller and Louppe, 1994: 6). Consequently, the Single European Act, which set the objective of creating an internal market in the European Community by December 1992, came into effect in July 1987. When the Commission drew up an inventory of obstacles to an Internal Energy Market in 1988, it identified most of them in the fields of electricity and gas (Eising, 2002: 92). The European Commission therefore applied Community law to these sectors, and set out the development of an internal market for electricity and gas. At the European level, the liberalization of the electricity industry was thus not necessarily driven by a bad performance of the sector, exemplified by for instance high electricity prices or low quality of the goods and services provided, but by an objective of creating an internal market in Europe.
The national governments of the European countries responded in different ways to the proposals of the European Commission to liberalize the electricity industry. The basic policy preferences of Member States over the main organizing principle of their domestic sectors can be summarized as either a preference for competition or a preference for monopoly (Eising, 2002: 86). The United Kingdom was an early adopter of the proposals of the European Commission. Already in the 1980s, economic policies, devised by a conservative UK government, set out to privatize and liberalize various sectors in England and Wales, including the electricity industry. With respect to this electricity industry in England and Wales, Green (2006: 2533-2533) argued that the movement towards deregulation has been imposed from outside the industry concerned, and that it would be patently false to claim that this deregulation was solely or mainly pursued at the behest of the electricity industry. In other countries, such as France, the government aimed instead to retain its national champion that supplied electricity to virtually all of the consumers.
Dutch liberalization
The consecutive Dutch governments that have implemented the EC directives have been in favour of unbundling the industry and of stimulating the creation of an electricity market. The liberalization of the Dutch electricity industry started with the electricity law of 1998. This law appointed TenneT as the transmission network operator for the Dutch high-voltage network, thereby replacing the SEP. The law of 1998 transposed the EC electricity directive of 1996 (96/92/EC), and was amended several times, by the law of July 2004 and the law of November 2006. The law of July 2004 implemented the EC electricity directive of 2003 (2003/54/EC), while the law of November 2006 obliged an independence of the Dutch network operators that extends beyond the European requirements for unbundling. This Dutch law prescribes the ownership unbundling of the network operators from the producers and retailers of electricity, whereas the EC directives are limited to a legal unbundling of the integrated energy firms. The law also states that the regulator for the Dutch electricity industry should promote an electricity market and the effective functioning of this market.
The transactions in the Dutch electricity industry, including the balancing transactions, are thus being affected, during the last decades, by a substantial and regulated governance change. The vertically integrated pooling system has to make room for more decentralized structures, that should re-organize and re-coordinate the segments in the value chain that have recently been unbundled in terms of their ownership. With respect to the balancing of electricity supply and demand, the 1998 law states that the transmission network operator has the obligation to provide system services, which includes the service to balance the electricity system. When the network operator purchases energy to provide system services, it has to use a transparent and non-discriminatory procedure. The tariff that the network operator charges for maintaining the balance should also be transparent and non-discriminatory, and should reflect the costs that are made for maintaining the balance (article 27.3 of the 1998 electricity law).
The liberalization of the Dutch electricity industry has been driven by the European directives and a preference for competition by the Dutch policy makers, but not by abad performance of the industry. Although in 1999, the Dutch government claimed that the liberalization of the Dutch electricity industry would lead to decreasing prices for consumers (Tweede Kamer, 1999), the electricity prices for the Dutch consumers have instead increased substantially since 1999. The prices for the delivery of electricity to the consumers increased with 132 per cent between 2000 and 2009 (see table 1), which is a large increase, especially when compared to inflation of 24 per cent over the same period (CBS Statistics Netherlands, 2010).