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Birth of the Euro

Roth, Steve

Energy Markets 7. 1 (Jan 2002): 24.

Abstract (summary)

The trend, however, seems unstoppable-despite the legal, regulatory and physical constraints. "There is increasing liberalization of the energy environment," says [Anthony Browne]. "Liberalization means the removal of barriers, and that is resulting in more and more integration of internal and international energy markets." Liberalization also is bringing on a revolution in wholesale electricity trading.

Full text

FINANCE & CAPITAL

The issue of euro notes and coins has sparked fresh thought on the future of the European energy industry. It seems that the tide for greater integration is now unstoppable.

At midnight Dec. 31, 2001, millions of Europeans witnessed a unique birth. Thirty years after conception, the euro became a physical currency with its own banknotes and coins. In Ireland, Belgium, France, Portugal, Spain, the Netherlands, Italy, Greece, Finland, Luxembourg, Austria and Germany, the old national currencies have been phased out.

By Feb. 28-after a brief conversion period-the French franc, the Dutch guilder and eight other national currencies will cease to be legal tender (Germany is currently the only country that has said its currency is no longer legal tender after start of the new year.) After that it will only be possible to change old currency to euros at commercial or central banks.

PREPARATION

Companies have had considerable time to prepare for the euro: most will have been dual accounting or accounting in euros for some time. In Spain, for example, utilities switched to billing in euros in September. In Belgium and Italy, utility bills are also already billed in euros (except in Italy, where the plural of euro will be euri). In Germany, RWE has been billing customers in euros for some time (a Deutschmark amount is included on the bill for information only).

Nevertheless, the removal of national currencies brings immediate benefit. Transaction costs will fall as companies will no longer have to bill in dual currencies. On the other hand, some costs may rise. Gas prices are tied to the price of oil, which is denominated in dollars. To the extent that the euro is slipping against the dollar there will be an increase in fuel costs. This is likely to be temporary, says Anthony Browne, global leader, corporate finance in PricewaterhouseCoopers' energy practice. "I think there we will see increasing de-linking of gas and oil prices. There is no reason gas and oil should be linked. Increasingly they function as separate markets. OPEC determines the oil price while gas is a free market. So the euro/dollar exchange rate will become less and less important." There also may be some residual implementation costs.

Contrary to popular wisdom, the euro will not bring true price transparency, says Rebecca Reehal, an analyst with Lehman Brothers in London. "There isn't the unbundling there is in the U.K. It's impossible for someone served by a vertically integrated company to work out how the final price is calculated. Also, there is still quite a lot of cross subsidy across the value chain and this is more apparent in some countries than others." Certainly, there is no expectation customers will shop around substantially more than at present, says Wolfgang Schley of RWE Plus. "It is not a big issue for the company."

INTEGRATION CATALYST

The euro may not be a significant change for the energy industry; nevertheless, it has been a catalyst for fresh declarations regarding further integration of the European energy market. Spain has made a commitment to liberalization and interconnection of European electricity and gas markets a priority of its forthcoming EU presidency. Writing in the UR press last week, the UX Prime Minister Tony Blair and Spanish Prime Minister Jose Maria Aznar linked the image of unity conjured by the euro to the need for greater reform of European markets, particularly energy. Writing for the Guardian newspaper they said: "There need to be fewer unnecessary regulations. The EU must stimulate closer cross-border cooperation in areas such as energy infrastructure, patents and unified capital markets." They added that, "the single currency makes a truly open and dynamic market essential."

Most economists and regulatory experts expect further integration. But opinions vary as to the extent. Franck Latremoliere of Europe Economics, an independent economic consultancy specializing in utility regulation and competition policy, says the electricity market is still highly underdeveloped.

"The retail electricity market is a local market. The wholesale market is only starting to develop anything other than long-term contracts between state entities: one part of the market rarely affects another. Set against that you have the gas market and the view that European prices are being imported into the U.K. through the interconnector: that is probably because the interconnector is so large compared to the size of the market." He says there is likely to be little or no integration of retail markets.

At the wholesale level, he expects a development of trading on medium- and long-term deals, but much depends on whether new interconnectors are built, access to the grid, and how much power is tied up in long-term agreements.

FALLING BARRIERS

The trend, however, seems unstoppable-despite the legal, regulatory and physical constraints. "There is increasing liberalization of the energy environment," says Browne. "Liberalization means the removal of barriers, and that is resulting in more and more integration of internal and international energy markets." Liberalization also is bringing on a revolution in wholesale electricity trading. "Exchanges are growing and are performing a very important role in providing liquidity to the market," says Browne. Exchanges, such as Nordpool, are beginning to trade forward. In September EdF auctioned 1127 MW of generating capacity products for execution from January 2002 with durations ranging from three months to three years. Sales are expected to reach 6 GW by 2004. "The sort of people who have been buying this capacity are going to trade that power and some of them will be exporting it," adds Browne.

A survey of the leaders of major European electricity utility companies, Electricite Sans Frontieres 2001, commissioned by PricewaterhouseCoopers, says European electricity companies are moving into an environment in which trading will not be an option but a critical part of business. Only a fifth of companies involved describe the purpose of their trading activities as pure hedging to minimize risk. Some 42% see trading as a way to pursue a variety of objectives, according to the survey, suggesting many companies will be managing trading to balance risk and reward with the objective of achieving a return from the activity. Responses suggest that utilities believe constraints on the physical flow of electricity across geographic borders will continue into the immediate future and energy trading will be regional rather than pan-European. The picture is of neighboring countries coalescing around regional hubs. In time, two or three exchanges will rule the roost. Asked which exchanges they see leading the field in five years time, Frankfurt, Nordpool and IPE were the top three named.

"I think its inevitable there will be a consolidation," says Browne. "There is going to be more and more cross-border trading of electricity, particularly as new entrants join the EU and start moving their electricity into the European grid. It's quite clear that the EU is continuing to push for grid liberalization. The amount of power and amount of trading is always going to be small in absolute terms, but it is going to be very, very significant because that will drive the decisions about where to site power stations.

Countries such as Slovakia, where labor costs are low, will be prime areas to site plant," Browne says. That will drive the investment in interconnectors and speed European integration. Not surprisingly, there is fierce competition for position in the liberalized market. Consolidation is likely to leave five or six companies playing a leading role, according to the survey. Asked whom, over a third of respondents said EdF. Behind EdF came E.ON, RWE, Endesa and Vatenfall. Together these five accounted for 84% of responses. However, industry players are skeptical about the chances of politicians and officials removing obstacles to a "level playing field" for European utilities. Around half of the companies interviewed thought it was "highly unlikely" or "unlikely" that there would be any short-term removal of political or

regulatory barriers. Hopes for true market harmonization remain someway distant, according to PwC.

LIQUIDITY NECESSARY

A number of companies have formed alliances to gain some of the advantages of hedging. "We are beginning to see a number of alliances between upstream generators and producers and downstream retailers," says Reehal. The recent alliance between Dalkia and EdF is one example. But, Reehal adds that, "In order to get proper competition you need the interconnectors."

PwC agrees. "If there is to be a leading panEuropean power exchange, the cross-border physical capacity restraints must be removed and power exchanges themselves must innovate and provide liquidity and a range of physical and paper products that allow for effective cross-border trading. Geography will eventually fade into the background, especially as more exchanges become Internet based, and companies will seek to transact business where the most favorable trading mechanisms are on offer. The race to create the leading European exchange and trading platform remains wide open," concludes PwC.

In fact, the field is growing. A new French exchange opened in November. Powemext, appointed to run the exchange, brings together major European players in electricity trading and financial markets: Euronext Paris; HGRT, a European transmission system operator holding company involving RTE, Elia and Tennet; BNP Paribas; Electrabel; EdF; Societe Generate; TotalFinaElf Atel and Endesa.

PRICE TRANSPARENCY

The exchange, in partnerships with Nordpool and Clearnet (a European clearinghouse and Euronext subsidiary), deals in day-ahead transactions on standard contracts for the physical delivery of electricity to the French hub. Powernext says organized and transparent exchanges will enable consumers to access a diversified panel of short-term supply sources and generators to acquire greater flexibility in managing supply. Powernext will guarantee price transparency while preserving operator anonymity and will provide reference prices serving operators, consumers and generators. CEO jean-Francois Conil-Lacoste says it also will reduce, if not eliminate, counterparty risk.

Conil-Lacoste believes the time is right for a new exchange. "There is undoubtedly the emergence of an over-the-counter wholesale market in France, and signs indicate that this will be more significant as time goes on. Also, there is room for an organized market that brings to the table the merits of centralization and increases liquidity by concentrating a larger spectrum of supply and demand," he says.

There also is France's position as a central European hub. "If you look at the number of initiatives in Europe you see new exchanges here and there. If you look at the map it seems a little bit bizarre that in the country-with one of the privileged locations, on the crossroad of many power routes-you have nothing. It is filling a vacuum," says ConilLacoste. He also

believes the exchange will encourage opening of the French market and the liberalization of the European energy market.

Its first goal is to set up an indisputable reference price by bringing together the maximum available supply and demand. "We know supply is relatively limited. On the other hand we have the assets of having one unique French hub; we have a regulator, we have many assets. To set up a reference price would be quite valuable to the community."

The second goal is to help reduce the fragmentation of the spot market in Europe. "We have a holding company of DSOs-RTE, Elia; a diversity of producers from a range of countries. That gives us a better capacity to tackle some critical problems, such as the problem of fluidity on the borders, information flows, etc.," he says.

The third aim is to launch a unified financial market for energy products. Conil-Lacoste says this can only come on the basis of strong spot markets. Unlike the spot market, these could lead to two or three mega-exchanges where traders could engage in one-stop shopping for gas, electricity, permits, weather derivatives and so on.

Conil-Lacoste thinks the spot market will remain at a national level for security and political reasons. However, there may be a degree of de-fragmentation. "I hope we can see something like Nordpool in place. We could see a hub that takes in the Benelux countries, perhaps a common zone with Spain and Italy."

Ultimately, however, Conil-Lacoste also wants to see more physical capacity. The pressure is there. As Browne says, trading (like the euro) is no longer an option. The new European energy market makes it an essential part of everyday business life.