Student:FedericoFaleschini Module:EnergySecurityPolicy ModuleConvenor:AndreyBieljy Programme:JointMasterProgrammewithUniversityofKent 19December2011

CantheENERGY2020StrategyBe Competitive,SustainableandSecure?
TheClashbetweenMarketLiberalisation,TechnologicalChangeand EnergySecurity

IntroductionandResearchQuestion IntheusualemphaticEUjargon,thelatestenergypolicydocumentbytheCommissionis called ENERGY 2020: a strategy for competitive, sustainable and secure energy. These three adjectivessumupthemostimportantchallengesthattheEuropeanenergysectorfacesintheearly XXIcentury:keepenergypricescompetitiveinordertostimulatetheeconomicgrowth,making energyproductionandconsumptionsustainable(i.e.alongtermgoalofadecarbonizedeconomy) andensurethesecurityofsupply. Theaimofthisessayisexactlytoanswerthisquestion:Arethegoalsofacompetitive, sustainableandsecureenergycompatible?.Gettingtheanswertothisquestionrightmightwellbe themostfundamentalachievementofEuropeanenergysectorresearch:indeedthisisanelemental issue,becausedependingontheanswerdifferentpolicieswillbeadvisable.Shouldthethreegoals turnouttobenotcompatible,noamountofambitionwillbeenoughandbetterresultscanbe achievedbyfocusingonlyontheattainablegoals. Thestructureoftheessayisasfollows.Thefirstpartisgoingtopresentthemajorpointsof the Energy2020 strategy(hereafterE2020S).Thesecondsectionisgoingtodiscusswhetherthe doublegoalofliberalisation(andlowpricesfortheconsumer)andtechnologicalshifttoalow carboneconomyarecompatible.Thethirdsectionfocuses ontheconstraints posedontheEU energypolicyandenergysecuritybythedependenceonnaturalgas'imports.Thefourthsection concludes. 1. TheEnergy2020Strategy TheE2020S(EC2010)strategyrevisesthesocalled20/20/20Strategy(EC2008),theEU'sboldest policydocumentinthefieldofclimatepolicy(and,asaconsequence,theenergysecuritypolicy). Thegoalsofthetwodirectivesarethesame:by2020EUmemberStates(hereafterMS)asawhole willhaveto(EC2008): CutGHGemissionreductionby20%,comparedto1990levels; Increaseto20%theshareofrenewableenergiesinEU'sfinalenergyconsumption; Achieve20%energysavingsthroughenergyefficiency,inrespecttothe2007baseline.

Thedifferencesbetweenthetwostrategiesaretobefoundintheimplementationmeasures.Forthe goalofthisarticle,thefocusshallbeonthefiveprioritiesoutlinedintheE2020S(EC2010:56): AchievinganenergyefficientEurope;

BuildingatrulypanEuropeanintegratedenergymarket; Empoweringconsumersandachievingthehighestlevelofsafetyandsecurity ExtendingEurope'sleadershipinenergytechnologyandinnovation; StrengtheningtheexternaldimensionoftheEUenergymarket.

WecanclassifytheIandIVgoalunderthe sustainabilitycategory,theIIandIIIonesunderthe competitiveness categoryandtheVoneunderthe security category.Weshallnowanalysethe relationbetweenthefirsttwocategoriestounderstandwhethertheyarecompatibleandmutually reinforcing. 2. Liberalisation,LowPricesandTechnologicalShiftintheelectricitysector Theliteratureontherelationsbetweenmarketliberalisationandradicaltechnologicalinnovationin theenergysectorisrelativelyrecentandmanystudiesarebeingconductedatpresent:thefirst conclusiontobemade,thus,isthatthereisstillnoacademicconsensus(Nez2007:1).Inthis section the relevant theoretical literature on the liberalisation of the electricity market will be analysed.Theelectricitymarketisthefocusofthemajorityoftheanalysisbecauseitisthemost liberalisedsector1. Thequestionofwhetherliberalisation,consumerprotection(intheformoflowerpricesthanin monopoly)andradicaltechnologicalchange(thedecarbonizationoftheeconomy)arecompatible canbebrokedowninthreeseparatequestions.Thefollowingsubsectionsanalyseeachquestion. 2.1. Isliberalisationcompatiblewithorevenconducivetoradicaltechnologicalchange? Markardetal.(2006)definetheenergysectorasalargetechnicalsystem[encompassing]a capitalintensive infrastructure, a broad range of technical components and technologies and a variety of actors and institutions [whose development] tends to be strongly pathdependent (ibidem:609).Whenradicalinnovationsinthesesystemsoccur,theyaretriggeredeitherbyexternal factors(newpolicypreferences,technologicalbreakthroughsinothersectors,)orbyinternal factors(socalledreversesalients,i.e.frictionsinspecificpartsofthesystem[which]hinderits []expansion(ibidem)).Intheenergysectortraditionallyradicalinnovationswerecausedby external factors, and liberalisation may be considered exactly such a thing, impacting the organizationalstructureofthesector. Duetotherelativelyshorttimespan,itisstilldifficulttomeasuretheeffectsofliberalizationonan
1 For an overview of liberalisation policies in OECD countries and the reaction of customers, see Anderson (2009).

expostbasis.Theauthorsthenresortedtoanempiricalsurveyamongelectricutilitiescompanies. Themainfindingsarethefollowing: Changeoffirms'guidelinesforinnovation:undermonopolyconditionsinnovationmainly meant improving existing standards. After liberalisation cost efficiency and customer satisfactionbecamethemainpriorities;atthesametimealbeittheroomforexperimentation increased,theriskierbusinessenvironmentoftenshiftedthefocustoshortertermandless capitalintensiveprojects; Changeofinnovationenvironmentatthesector'slevel:inaliberalisedmarketthemain driver for innovation is the demand side, together with regulatory pressures, while in monopolyconditiondisseminationofnewstandardswascentrallyplanned. Theauthorshintthatoverallchangespointtoapossiblemarketoriginatedpressuretobreakpath dependency:indeedmarketcompetitionmaywellfavourradicalchangebymakingasittingonthe fenceattitudetooriskyforcompanies(eventheincumbentones).Theauthorshoweverfindno conclusiveevidenceinthisrespect:theeffectsofliberalisationaretoogeneralandstilluncertain. Otherstudieshaveconcentratedontheimpactofliberalisationonthefinancialstrategyof thefirms. Szab etal. (2008)modelinvestors'behaviourintheliberalizedenergymarketinthe 20052030timeframe.Twocharacteristicsofthemodelstandout: Theassumptionofcostminimisationbehaviourbypartofallfirms:thisentailstheuseof decliningReturnOnInvestment(ROI)asaproxyforincreasedcompetition insteadofthe marketconcentrationindex.ThemostimportantconsequenceofadecliningROIisthatthe difference in the net present values of investments with different cash flows decreases (ibidem:1437)makinginvestmentswithhighupfrontcosts(suchasrenewableenergies) moreattractivethaninascenariowithhighandstableROI; Theapplicationofa parametriclearningfunction,definingtherelationbetweentheunit investmentcostreductionandcumulatedcapacitiesbuiltinthemodel(ibidem:1440),i.e. thehigherthecumulatedcapacitythelowertheoperationalcosts. TheeffectofadecliningROIduetotheliberalisationofthemarket(i.e.inacompetitivescenario) is said to be very strong, favouring the massive expansion of renewable energies also in the generation of middle load capacity, thus almostoffsetting mostof the increase in natural gas generation(ibidem:1442).Inrespecttothetechnologicallearning,onlyphotovoltaictechnology benefitsfromsubstantialcostreductionsgiven100foldcapacityexpansionpredictedbythemodel. Theauthorsthusfindthatacompetitive,liberalisedmarket(especiallyinrespecttothefinancial structure,whichshouldusea longertime horizon coveringtheentire lifetime oftheassets)is

stronglyconducivetotheexpansionofrenewableenergiescapacities. Thesituationisdifferentwhenconsideringthepoliciesforenergyefficiency.AsGoloveet al.(1996)clearlyshowbydrawingfromNeoclassicalandTransactionalCostseconomics,thereis clearevidenceoftheexistenceofmarketfailures inthemarketforenergyefficiencyservices: environmental externalities, imperfect competition, the status of public good and, above all, imperfectinformation.Amarketfailurewarrantstheinterventionoftheregulatorinordertocreate amarketforenergyefficiencyservices.Thusliberalisationofenergyefficiencyservicesisalways limitedtosomeextent(althoughnosinglebest[government]policysolution(ibidem:34)exists). 2.2. Is consumer protection (in the form of lower electricity prices) compatible with radical technological change? Intheirmodel,Szabetal.(2008)(seesection2.1)predictthatinthelongtermperiodprice increasesareunavoidablebothintheBAUscenarioandintheliberalised(competitive)one,dueto thehighupfrontcostofrenewableenergiesandtheincreasingpriceofCO 2emissions2.Thereforeit canbesafelysaidthatlowenergypricesandexpansionofrenewableenergiesarenotcompatible. Howevertheyfindthatintheliberalisedscenariothemorecompetitivefinancialstructureallowsa smoothertransitiontothehigherpricesand,moreimportant,alessexpensivesupportschemefor renewable energies (photovoltaic in particular) for the same level of energy production. Liberalisation then seems to be the least expensive option to achieve high levels of electricity productionfromrenewablesource. DrawingfromdatarelativetoIsraelienergymarket,Milsteinetal.(2011)findyetanother evidenceoftheincompatibilitybetweenlowpricesandrenewableenergiespromotion.Themodel assumes only combined cycle gas turbine (CCGT) and photovoltaic technologies, in order to approximatefossilfuelsandnuclearpowerontheonehandandrenewableenergiesontheother. Theauthorsmaintainthattheweatherdependenceofrenewableenergysources(ibidem:3922) andtheimpossibilityofstoringelectricalpowermakespricespikesandhigheraverageelectricity pricesmorelikelythelargertherenewableenergycapacityis:indeedhighpricespikescombined withlowpriceelasticitygivesproducersadegreeofmonopolypower.Onlyheavyinvestmentinto theinfrastructurecanminimizethenegativeeffectsoftherenewablesources'weatherdependence. Therearecaseshoweverwhichpromotebothconsumerwelfareanddecarbonizationofthe economy,butgocountertheliberalisationprocess.Brennan(2011)showsthataregulatorwhichis primarilyconcernedwith consumer welfareand promotion ofenergy efficiency and renewable
2 The sensitivity analysis show that the results are heavily dependent on the evolution of the ROI, investment cost (i.e. technological learning rate) and CO2 cost factors, which are indeed very difficult to forecast.

energiesmaybebetteroffactingasamonopsony(i.e.asinglebuyer),thusdistortingdistorting marketcompetition.Brennan'scaseismoreconvincinginthecaseofenergyefficiencymeasures. He argues that If supply [of electricity] is less than perfectly elastic, rendering monopsony profitable,aregulatormotivatedsolelybyconsumerwelfarewouldsubsidizeenergyefficiencyto reducedemandforelectricityandthusitsprice,evenifconsumersbearthefullcostofthesubsidy 3 (ibidem:3958).Inordertodoso,however,theregulatorhastofulfiltworequisites:first,possess substantivemarketpowerandsecond,notbeingunderalegalobligationtoensurethatregulated utilitiesrecovertheircosts.Energyefficiencythuscanpromoteconsumerwelfare,butonlyatthe costofdistortedmarketcompetition. 2.3. Isliberalisationcompatiblewithorevenconducivetoconsumerprotection(intheformof lowerelectricityprices)? The evidence is still very mixed, due to the recent implementation of the liberalisation measures.IntheiranalysisoftheUKmarket,aforerunnerofenergysectorsliberalisation(both electricityandgas),Ferreira etal. (2005)findoutthatliberalisationhasindeedbeenextremely positiveinloweringenergyprices:Compared to 1990, the year of the beginning of the electricity reforms, average electricity prices in 2002 were 42% lower for the industrial sector and 26% lower in the residential sector. (ibidem: 2246). However they find that the interfuel competition, an importantbuildingblockofatrulycompetitiveenergy(notonlyelectricity)market,isstillweak: indeedcorrelationofenergypricesonlyexistsinthelongrun,indicatingaslowresponsivenessof theenergymarkets(ibidem:2254).Thisslowresponsivenessisinparttoblameonthestrong technologicalconstraintsthatenergydemandfaces(switchingfuelmaynotbeeasyintheshort term,requiringhighinvestments). NotwithstandingthepositiveUKexperience,thebeneficialeffectsofmarketliberalisation asithasbeenimplementeduptonowarenotsharedbyallscholars.ForexampleAnderson(2009) claimsthatalthoughtrueliberalisationwouldsurelyyieldbenefitsforenergyconsumers,thereisa realconcernthatthecharacteristicsoftheenergysectormaketrueliberalisationimpossible:thus the current implementation of market schemes offers the worse of both worlds, not protecting consumersnorpromotingtruecompetition.Thisleadsustothenextsection,whichfocusesonthe EUgassector,whoseliberalisationisprovingdifficult,withnoevidentgainsfortheconsumers. 3. LiberalisationandEnergySecurity:thegasmarkets
3 The assumption of less-than-perfect supply elasticity is needed in order to rule out the so-called rebound effect, i.e. an increase in energy consumption as a consequence of energy efficiency measures, which augment the utility consumers can get from every unity of energy they consume.

According to Brakman et al. (2009), The EU gas sector has three key features: (1) imperfect competition of the Cournot oligopoly type [since few countries possess natural gas reserves]withproducthomogeneity;(2)(potential)gassuppliersthatcanberankedfromhighto low efficiency;and(3)capacity constraints foreachand every(potential)gas supplier [dueto increasingexplorationcostsandfixeddistributionnetwork](ibidem:32).Itfollowsthatthetighter theconstraints,themorethepriceswillbedeterminedintheresidualmarketonlyi.e.determinedby thefirmsleastconstrained,i.e.theoneswhichhavethelargestuntappedreserves.Thereforethe higherthecapacityconstraints,themorefirmswillbewillingtoenterthemarket,sinceevenvery uncompetitivefirmswillbeabletosustainthehighcostsnecessarytoexploitincreasinglydifficult toexploitreservesaslongaspricesaredeterminedintheresidualmarket.Itmustalsobenotedthat theprojectedincreaseingasdemandbytheEUexacerbatesthistreacherousdynamic. Themainpointisthatinsuchasituation,thenumberoffirmsisnotagoodindicatorofthereal levelofcompetition.Quitethecontraryindeed.Thepoliticsofliberalisationofthegassectorinthe EUhoweversimplyassumethatthehigherthenumberoffirms,themorecompetitivethemarket. Thisdoesnotalwaysholdtrueandshouldbeconsideredmorecarefully. Uptothispointthediscussionhasalwaystreatedenergyasanonstrategiccommodity.This howeverisagrosssimplification:energyisastrategiccommodity(Liuto2009:120)andhashigh political significance. As noted by Correlj et al. (2008), the EU clearly continues to frame internationalrelationsinthe Marketsandinstitutions narratives:ascenariowhereeverstronger globalizationandtraderelationsforcesallcountriestocooperate,depoliticizingenergyrelations. Ontheotherhandtherestoftheworld,andRussiainparticular,subscribetothe Regionsand Empiresscenario:regionalblocksemergeandcompeteforstrategicresources,withenergyrelations becoming highly politicized. Each scenario's assumptions have strong consequences for the definitionofenergysecurity:indeedtheMarketandInstitutionsnarrativeentailstheintegrationof worldmarketsandtheprotectionofinvestmentasmeanstoattainenergysecurity,whilethe RegionsandEmpiresnarrativesportraysenergysecurityasthevictoryofapowerstruggleoverthe possession of energy resources, which in turn is reflected on firms' behaviour (influenced by politicalpressures). AsMcGowan(2009)pointsout,theRussiaUkrainegastransportcrisisof2006and2009 actedasaviolentwakeupcallfortheEU.TheEUhoweverdidnotabandonitsliberalstance,both intheexternalandtheinternalenergypolicy.Inparticular,theexternalstrategymainlyconsistedin the expansion of the EU energy market rules, an offer constantly rejected by Algeria and (especially)Russia(thetwobiggestEUgassuppliers).WhiletheEUexternalstrategyhasnot

significantlychangedyet,theongoingliberalisationprocessoftheinternalmarkethasreceived anotherblow:worriedbythemergersandacquisitionsoftheRussianandAlgerianmonopoliesin the EU internal market, the Commission has taken protectionist measures to prevent energy producersinthirdcountriestocontroldownstreamassets,lesttheydonotopentheirowninternal markets.Itisindeedstrikingthatthe RegionsandEmpire narrativeintheenergysectorbecame increasinglystrongeveninsidetheEUinthelastfewyears,withthebiggermemberStatesresisting theunbundlingoftheirnationalchampions(ibidem:102).ResourceNationalismindeedseemsto beamuchbiggerconcernforallrelevantactors,puttingtheEUliberalenergypolicyatoddswith theveryEUenergysecurity. 4. Conclusion:Competitive,SustainableandSecure?Picktwo,leaveone Theaimofthisessaywastoanswerthequestion:Arethegoalsofacompetitive,sustainableand secureenergycompatible?.Inordertodosotheessayhasfirstbrieflyoutlinedthemajorpointsof theE2020S,thenithascoveredtherelevantaspectsthederegulationprocessintheelectricitysector andfinallyithasanalysedthegasmarketandtheexternalconstraintsfacedbytheEUinthissector. Themajorfindingsarethefollowing: Thereisnoactualevidenceyetthatliberalisationintheelectricitysectorisconduciveto radicaltechnologicalchange,althoughthemodelsreviewedstronglypointinthisdirection; TheanalysisofmatureandcompetitiveelectricitymarketssuchastheBritishoneshowsthat liberalisationperseisconducivetolowerpricesfortheconsumers,butthisoutcomeisstill stronglyconditionalontheworldenergyprices; Thesupporttorenewableenergysourceswillhaveanheavyimpactontheenergyprice, bothbecauseofthehighupfrontcostsandbecauseofthewideranginginvestmentsneeded toupdatetheenergyinfrastructure; ThecharacteristicsoftheEUgasindustry,byitsverynatureanoligopoly(fewproducing countriesandfixedtransportationinfrastructures),limitthescopeofapplicationofliberal policies,bothintheexternalandinternaldimension. Toconclude,theanswertotheopeningquestionmustbeNO.Sustainabilityrequiresliberalisation andhighprices,whileSecurityrequireslessliberalisation(aslongasexternalconditionsstaythe same).Competitivenessentailsliberalisationtoincreasetheshareofrenewableenergiesinthemost costeffectiveway,butthiswillbeinevitablyreflectedintheconsumer'sbill.TheEUleadersshould craftanew,morerealisticenergypolicy,reflectingrealpossibilitiesandconstraints.

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