Introduction to the Regulation of Electricity Markets

The Third Electricity Directive gave new incentives to invest in new power generation capacity. There were two main changes.

While the Second Directive recognised “the nature of the primary sources” as part of the permitted criteria for the grant of authorisations for the construction of generating capacity,¹⁰³ the third Directive went much further in fostering investment in energy from renewable sources and the reduction of emissions.¹⁰⁴ In addition, the Third Directive was designed to foster investment in decentralised electricity generation.¹⁰⁵

The Second Directive gave all customers the right to choose their suppliers. The Third Directive increased competition in both the retail and the wholesale market by giving large non-household customers a right to enter into contracts with several suppliers to secure their electricity requirements. Such customers were thus protected against exclusivity clauses.¹⁰⁶

One of the main goals of the Third Electricity Directive was to achieve non-discriminatory network access.¹⁰⁷ Non-discriminatory grid access at the transmission level determines downstream access to customers at the retail level.¹⁰⁸ Competition can be increased further by cross-border grid access for new suppliers of electricity.¹⁰⁹

Creating the internal electricity market would not have been possible without particular third-party access rights (TPA rights) for electricity firms.¹¹⁰ The European Commission based the legislative reforms that lead to TPA rights on three foundations. The first was that the technique of an imposed competition based on obligatory access was already part of EU competition law.¹¹¹ The second was that the energy sector was subject to an extensive regulatory framework in the Member States.¹¹² Competition law would not have been enough to open markets.¹¹³ The third was the prevailing view that the provision of energy is a public service.¹¹⁴

This is reflected in the Third Electricity Directive. According to the Directive, the Member States may impose on undertakings operating in the electricity sector, in the general economic interest, public service obligations.¹¹⁵ There must also be a system of third party access to the transmission and distribution systems. It must be based on published tariffs, applicable to all eligible customers, and applied objectively and without discrimination between system users.¹¹⁶ The transmission or distribution system operator may not refuse access unless it lacks the necessary capacity.¹¹⁷ The Member States may also take measures to ensure a level playing field.¹¹⁸ Such measures must be proportionate, non-discriminatory and transparent.¹¹⁹

On the other hand, there are limitations to third party access rights.

First, the corresponding duties to grant third party access apply to transmission or distribution system operators. They do not apply to electricity firms that cannot be regarded as TSOs or DSOs. In citiworks, the CJEU noted that voltage is the sole distinguishing criterion between transmission and distribution.¹²⁰ Particular transmission or distribution systems were not excluded from the scope of the Second Electricity Directive by reason of their size or consumption of electricity. There were particular rules for “small isolated systems” and “micro isolated systems”.¹²¹

Second, third party access rights do not include the right to be connected to the grid. In Sabatauskas,¹²² the question was whether a party is free to choose the system (a transmission system or a distribution system) to which it wishes to connect and whether the system operator must permit connection to the system.¹²³ According to the CJEU, the terms “access” and “connection” mean different things. The term “access” is linked to the supply of electricity. The term “connection” is used in a technical context and relates to physical connection to the system. Therefore, third party access rights under the Second Electricity Directive did not include connection to the system.¹²⁴

Third, refusal to permit a grid connection or access to the grid does not always amount to abuse of a dominant position (Article 102 TFEU, see Sect. 3.7).

While the Second Electricity Directive required legal and functional/operational unbundling but not ownership unbundling, the Third Directive requires “effective unbundling”. Effective unbundling means the “effective separation of networks from activities of generation and supply”.¹²⁵

US wholesale markets and interstate transmission are regulated by the Federal Energy Regulatory Commission (FERC). In 1996, the FERC ordered utilities to unbundle their generation, transmission, and distribution functions and provide non-discriminatory access to the national electricity grid (FERC Order 888).¹²⁶

According to the Third Electricity Directive, security of supply is fostered in three main ways. (a) The first is the independence of system operators facilitated by unbundling.¹²⁷ (b) The second is investment in electricity generation. Investments are made easier by unbundling and pricing signals.¹²⁸ (c) The third is the development of interconnections.

There can be no internal market for electricity without cross-border interconnections. Without cross-border interconnections, it would be difficult to reach the Directive’s objectives relating to security of supply and competitive prices.¹²⁹ For this reason, the Third Electricity Directive requires the Member States to provide adequate economic incentives for the maintenance and construction of interconnection capacity and to enable an adequate level of interconnection capacity even in other ways.¹³⁰

The electricity directives recognise that the free movement of goods, the freedom of establishment, and the freedom to provide services are rights guaranteed by the TFEU to EU citizens.¹⁴² It is assumed that these rights are achievable only in a “fully open market”. A fully open electricity market is a market that enables “all consumers freely to choose their suppliers and all suppliers freely to deliver to their customers”.¹⁴³

This reflects the case-law of the CJEU according to which measures which hinder access to the market fall within the scope of the free movement of goods regardless of whether they are discriminatory or not.¹⁴⁴

In addition to guaranteeing the four freedoms to EU citizens, the purpose of the internal market in electricity is to reduce costs, improve standards of service, and reduce risk. In particular, it tries to “achieve efficiency gains, competitive prices, and higher standards of service, and to contribute to security of supply and sustainability”.¹⁴⁵

The benefits are to be achieved when electricity consumers and electricity firms use the freedoms guaranteed to them. The four freedoms are expected to result in “real choice” given to all electricity consumers, new business opportunities, and an increase in cross-border trade.¹⁴⁶

However, the focus is on the retail market and the consumer perspective rather than the wholesale market and the perspective of electricity producers. This is regardless of the fact that the role of the wholesale market is recognised¹⁴⁷ and there are third-party access rights (TPA rights). There is no “fully open market” for producers. (a) While the electricity directives regulate “security of supply” for consumers, they fail to regulate security of consumption/off-take for electricity producers or suppliers. (b) The electricity directives do not ensure a level playing field for electricity producers. Different technologies are treated differently. Because of the preferential treatment of RES-E, the regulation of electricity markets makes it more difficult for electricity producers to find consumers depending on the Member State and the fuel or technology. These kinds of differences are likely to affect electricity trade between the Member States. (c) Pricing is regulated rather than free. The underlying assumption is that prices can “impair competition and proper functioning of the market”.¹⁴⁸ The electricity directives are designed to limit prices paid by end consumers¹⁴⁹ and not designed to enable wholesale market participants to profit from the market mechanism. Tampering with the market mechanism can have an adverse effect on investment in generation installations and increase electricity prices in the long run contrary to the stated objectives of the electricity directives.¹⁵⁰ One of the proposed ways to address this problem is tampering with clearing prices in the day-ahead and intraday markets or “the introduction of harmonized maximum and minimum clearing prices that contribute to the strengthening of investment conditions”.¹⁵¹ (d) The broad scope of unbundling provisions can increase entry barriers (Sect. 3.5.6).

In principle, EU law should guarantee a level playing field in the internal market even for electricity producers by the prohibition of quantitative restrictions and measures having equivalent effect,¹⁵² by the regulation of state monopolies (such as state-owned TSOs),¹⁵³ by the prohibition of state aid,¹⁵⁴ and in other ways.

The unbundling regime does not apply to distribution systems with its full force. There can be various categories of DSOs in this respect: DSOs that fall or do not fall within the scope of the unbundling regime; DSOs subject or not subject to ownership unbundling requirements; and DSOs subject or not subject to requirements as to the independence of organisation and decision-making.¹⁶⁷ (a) A Member State may decide not to apply the regime to “integrated electricity undertakings serving less than 100,000 connected customers, or serving small isolated systems”.¹⁶⁸ (b) There is no mandatory ownership unbundling for distribution assets under the Third Electricity Directive.¹⁶⁹ (c) Where the distribution system operator is part of a vertically integrated undertaking, it must be “independent in terms of its organisation and decision-making from the other activities not related to distribution”.¹⁷⁰

One may ask what happens when a vertically integrated public utility is divided into a generation entity and a distribution entity. Can the separated entities both be public utilities? Would it mean that these entities are part of the same legal entity? In the context of transmission, the public bodies exercising control over the two entities would have to be separate public bodies in order not to be regarded as the same person.¹⁷¹ This question may not always have been properly understood in the past.¹⁷²

There is a stricter regime for transmission system owners or operators controlled by a person from a third country. The third country clause is also known as the Gazprom clause. The Member State will refuse authorisation unless it is demonstrated that the entity complies with the unbundling requirements and that “granting certification will not put at risk the security of energy supply of the Member State and the Community”.¹⁷³

While these rights have been defined in the Third Electricity Directive,¹⁸⁴ the exercising of control has not been defined therein. The exercising of control is a broad concept.

Regardless of the recitals of the Third Electricity Directive,¹⁸⁵ it is possible that control is not limited to the types of control mentioned in the EC Merger Regulation. There are two reasons for this. First, the definition of the term “any right” under the Third Electricity Directive resembles the definition of control under the EC Merger Regulation.¹⁸⁶ This leaves the term control. The term control under the Third Directive should be given a meaning that makes it effective. Second, the EC Merger Regulation applies to the “concentration” of previously independent firms; concentration means change of control on a lasting basis.¹⁸⁷ For the purposes of the Third Electricity Directive, however, it should not be relevant whether control is exercised on a lasting basis. For instance, structured contracts can provide control over generation or transmission assets for a limited period of time (Sect. 8.​2).

In the absence of any other party exercising control, an undertaking is de facto controlled by its management.¹⁸⁸ A block of shares can also provide control. The size of the block depends on the firm. In practice, even a relatively small block of shares can provide control in large firms with a dispersed share ownership structure. There can thus be a controlling minority shareholding in many cases.¹⁸⁹ On the other hand, a minority shareholding is not prohibited as such as it does not always provide control.¹⁹⁰

In Finland, two generating companies (Fortum and Pohjolan Voima) were shareholders of the TSO (Fingrid). The regulator took steps to implement the new unbundling requirements. Fortum and Pohjolan Voima therefore divested their holding in Fingrid to the State of Finland and Ilmarinen, a mutual pension insurance company, in April 2011. After the transaction, Fingrid’s shares were held by the State of Finland and institutional investors.¹⁹¹

The rights mean here (a) voting rights; (b) the power to appoint members of the supervisory board, the administrative board, or bodies legally representing the undertaking; or (c) rights attached to a majority share.¹⁹² For instance, a person can hold a minority block of shares in an undertaking that belongs to the other category (provided that the person does not control that undertaking in other ways).

The wording of the Directive implies that the provisions on ownership unbundling do not prevent an undertaking belonging to one category (rather than a party controlling it) from having a non-controlling minority shareholding in an undertaking belonging to the other category.¹⁹³

One of the objectives of effective unbundling is to “create incentives for the necessary investments”.¹⁹⁴ Investments must be funded in one way or another. Obviously, it would be contrary to the stated purpose of effective unbundling to hamper infrastructure investments by restricting system operators’ access to funding.

Now, infrastructure investments are customarily funded by specialised and institutional investors that are likely to have invested in other energy projects as well. Whether they are permitted to provide the necessary funding can depend on the interpretation of the unbundling provisions.

How small should a block of shares be before it does not provide “control”? The question is relevant, because an institutional investor may have invested in the shares of an electricity producer in, say, Sweden and may want to subscribe for shares in a system operator in, say, Germany. Infrastructure investment will be hampered, if the threshold of “control” is low.

The Commission has clarified its practice in a staff working document.¹⁹⁵ Generally, the Commission does not want to refuse certification of a TSO “in cases where it can be clearly demonstrated that there is no incentive for a shareholder in a TSO to influence the TSO’s decision making to favour his generation, production and/or supply interest to the detriment of other network users”.

The Commission identified two main forms. The first was geographic separation of activities. In certain situations, “it was evident from the facts of the concrete case that the simultaneous participation in transmission activities on the one hand, and in generation, production and/or supply activities on the other hand, did not give rise to any potential conflict of interest or incentive to exploit it, and as a consequence did not in any way risk to impact negatively on the independent management of the TSO. This was for instance the case where a shareholder had a participation in a transmission network in the EU, as well as a participation in generation activities in the United States or in Australia, with no connection or interface between the energy systems concerned”.

The second related to the circumstances of financial investors: “For financial investors, ownership unbundled TSOs form an important class of potential investment opportunities, taking into account that investments in transmission infrastructure with regulated network tariffs offer stable, low risk returns that fit well with their investment profile. Cooperation with financial investors may enable ownership unbundled TSOs to raise the necessary funds for the capital expenditure that is needed to realise the investments in the EU energy network infrastructure. In situations as referred to above, where it can be clearly demonstrated that even though one or more of the circumstances referred to in Article 9(1)(b), (c) and/or (d) appear to be present, there is clearly no incentive for a shareholder in a TSO to influence the decision making in this TSO with the intention to favour its generation, production and/or supply interests to the detriment of other network users, the Commission has taken the view that a refusal to certify such a TSO given the fact that such participation in generation, production and/or supply activities does not lead to a situation which the unbundling rules seek to prevent”.

Can other forms of funding provide control? One of the ways for a firm to finance its activities is to use somebody else’s assets. To illustrate, the system operator does not have to raise other external funding to the extent that it can use assets owned by somebody else under a leasing agreement.¹⁹⁶ The question is when the ownership of transmission assets can be regarded as ownership of a transmission “system” and to what extent the ownership of a transmission system requires the ownership of transmission assets.

For instance, there are no requirements for ownership unbundling of DSOs in Finland. At the end of 2012, 9 DSOs operated a distribution network leased from their parent company. Other DSOs used some network assets such as substations under a lease contract.¹⁹⁷

Ownership unbundling raises even some questions relating to merchant lines. Investment in merchant lines could increase transmission capacity. However, the Third Electricity Directive does not recognise operators of merchant lines as such. This can hamper investment.

The Directive applies to “electricity undertakings”. This broad category includes even owners or operators of merchant lines regardless of how merchant lines are defined.¹⁹⁸ According to the terminology of the Directive, the functional equivalent of a merchant line could be an “interconnector”, that is, equipment used to link electricity systems¹⁹⁹ (rather than a “direct line”²⁰⁰).

However, the owner of transmission assets such as interconnectors should be a TSO. This seems reasonable in the light of the fact that an interconnector is similar to a simple transmission network in the physical sense. On the other hand, the function of an interconnector may also be close to a generation facility²⁰¹ and a TSO has more functions compared with the necessary functions of the operator of a merchant line.²⁰²

Neither Regulation 1228/2003 nor Regulation 714/2009 mentions merchant lines. There can be interconnectors that are owned by a natural or legal person separate from the system operators in whose systems the interconnector is built.²⁰³ That person can be a system operator.²⁰⁴

Horizontal foreclosure looks different in the context of electricity markets because of the physical characteristics of electricity. There are four important causes of foreclosure here: restriction of access to transmission networks (Chap. 5); vertical integration of network and supply activities (such as complete vertical integration or the integration of generation and distribution, Sect. 2.​3.​5); vertical integration of generation and retail (so-called integrated firms, Sect. 2.​3.​5); and exclusive long-term contracts (Chap. 8). They give rise to two forms of foreclosure: infrastructure foreclosure and market foreclosure.

Infrastructure foreclosure means the lack of access to electricity networks on transparent and non-discriminatory conditions. Restriction of access to transmission networks is a form of infrastructure foreclosure. Vertical integration of network and supply activities (complete vertical integration) increases the risk of infrastructure foreclosure. As European electricity markets cannot be opened up without network access, infrastructure foreclosure is something that the Commission and national competition authorities have focused on.

There are two forms of market foreclosure: vertical integration of generation and retail; and exclusive long-term contracts.

The Commission has investigated market foreclosure as alleged breaches of Article 102 TFEU. The investigated cases include: the limitation of transport capacities through refusal to deal or underinvestment; and market foreclosure through long-term supply or transmission capacity contracts.

In practice, it could be difficult to apply Article 101 TFEU to market foreclosure. Market foreclosure is often caused by the existence of market structures that are not effective, but Article 101 TFEU does not prohibit the existence of any particular market structure as such (for Article 102 TFEU, see Sect. 3.7.2).

There are three main forms of restricting access to transmission networks.

First, a TSO may have an incentive to abuse its natural monopoly.²⁸⁴

In Svenska Kraftnät, the issue was whether the Swedish electricity TSO had curtailed export transmission capacity on Swedish interconnectors to neighbouring countries. The curtailment of export transmission capacity means that domestically generated or imported electricity is reserved for domestic consumption contrary to the objective of creating an internal market for electricity.²⁸⁵ Svenska Kraftnät offered commitments that enabled it to manage congestion in the Swedish transmission system without limiting trading capacity on interconnectors, and commitments designed to reduce congestion.²⁸⁶

Second, a vertically integrated undertaking may have an incentive to restrict access to its transmission network to use the transmission capacity itself. The Commission has investigated such situations in the light of Article 102 TFEU in both gas²⁸⁷ and electricity markets.²⁸⁸

Third, the existence of long-term contracts for the use of transmission capacity can lead to infrastructure foreclosure (this issue is discussed in the context of market foreclosure through long-term contracts).

The Commission has applied principles developed under the concept of essential facilities. The first time the Commission used this concept explicitly was in Sea Containers/Stena Sealink.²⁸⁹

The essential facilities doctrine was imported to the EU from the US as a legal transplant. It first appeared in the US²⁹⁰ as a limitation to the main competition law rule that businesses may choose their contract parties (the Colgate doctrine).²⁹¹ The essential facilities doctrine is used to impose on owners of essential facilities a duty to deal with competitors. However, the essential facilities doctrine is nowadays regarded as a flawed means of deciding whether a unilateral, unconditional refusal to deal harms competition in the US.²⁹² The relevance of the essential facilities doctrine was reduced by the Trinko case.²⁹³

In Trinko, the Supreme Court declined to find a duty to deal. The Supreme Court argued: “Firms may acquire monopoly power by establishing an infrastructure that renders them uniquely suited to serve their customers. Compelling such firms to share the source of their advantage is in some tension with the underlying purpose of antitrust law, since it may lessen the incentive for the monopolist, the rival, or both to invest in those economically beneficial facilities. Enforced sharing also requires antitrust courts to act as central planners, identifying the proper price, quantity, and other terms of dealing—a role for which they are ill suited. Moreover, compelling negotiation between competitors may facilitate the supreme evil of antitrust: collusion. Thus, as a general matter, the Sherman Act ‘does not restrict the long recognized right of [a] trader or manufacturer engaged in an entirely private business, freely to exercise his own independent discretion as to parties with whom he will deal’”.²⁹⁴

On the other hand, the Supreme Court stated that the right to refuse to deal with rivals is not “unqualified”. The Court reserved the possibility that a refusal to cooperate with rivals can constitute anticompetitive conduct and violate §2 of the Sherman Act “[u]nder certain circumstances”.²⁹⁵

The European Court of Justice has dealt with refusals to deal in various cases after Commercial Solvents.²⁹⁶ Unlike the European Commission, however, the CJEU has not used the term “essential facilities”. In Bronner, the plaintiff argued that the essential facilities doctrine was established under the case-law of the CJEU,²⁹⁷ but the CJEU refused to use the concept of essential facilities. In addition, the CJEU restricted the scope of the duty to deal.²⁹⁸

In Bronner, it was not sufficient that the undertaking had a dominant position. The wording of Article 102 TFEU does not prohibit a dominant undertaking from doing things internally as a vertically integrated firm. An undertaking has a right to provide a service or refuse to do so even when it has a dominant position—subject to general competition law constraints such as the rule that a dominant undertaking may not use “methods different from those that condition normal competition” (Hoffmann-La Roche).²⁹⁹

The exercise of this right by a dominant undertaking may, in exceptional circumstances, constitute an abuse.³⁰⁰ According to judgment of the CJEU in Bronner, there are such exceptional circumstances where: (1) the service in itself is “indispensable” to carrying on the other party’s business because there is “no actual or potential substitute in existence” for the requested service; (2) the refusal to provide the service would be “likely to eliminate all competition” in the market on the part of the person requesting the service; and (3) the refusal would be “incapable of being objectively justified”.³⁰¹ In effect, the test laid down by the CJEU in Bronner prohibits the monopolisation of the market in a way that resembles §2 of the Sherman Act after Trinko but has a broader scope. Because the test is an objective one, it is not necessary to consider intent in the EU.³⁰²

An alternative approach could be the doctrine of strategic underinvestment.³⁰³ The prevailing view is that a dominant undertaking may have a duty to deal under the essential facilities doctrine under some circumstances, but no duty under Article 102 TFEU to expand existing facilities or construct new ones to improve market entry. The Commission seemed to share this view in its 2009 Guidance on Article 82 of the EC Treaty (now Article 102 TFEU).³⁰⁴ In ENI, however, the Commission indicated that there could be such an obligation, and investment commitments were used in Gaz de France/Suez.³⁰⁵

In ENI, the Commission discussed the relationship between the essential facilities doctrine and strategic underinvestment. If the holder of an essential facility has a dominant position and its capacities are fully used, it has, according to the Commission, an obligation to “take all possible measures to remove the constraints imposed by the lack of capacity and to organise its business in a manner that makes a maximum amount of capacity of the essential facility available”.³⁰⁶ The Commission identified the strategic limitation of investment as one of the competitive concerns of ENI’s alleged refusal to supply strategy.³⁰⁷ As the concerns were cleared when ENI divested its essential facility (transport business),³⁰⁸ it was not necessary for ENI to offer any investment commitments.

Gaz de France/Suez was a merger control case. A study by the CREG (Belgium’s Commission for Electricity and Gas Regulation) found a persistent state of (contractual) congestion on the Belgian gas transmission network caused by inadequate investment.³⁰⁹ According to the Commission, the proposed merger would have discouraged investment.³¹⁰ The parties undertook to make a series of investments to increase Belgian and French gas infrastructure capacity.³¹¹

The power to establish and enforce investment obligations would be problematic. One may ask whether Article 102 TFEU should vest such powers in competition authorities.³¹² First, the interpretation of Article 102 is constrained not only by the principle of proportionality³¹³ but also by the right to property and the freedom to conduct a business.³¹⁴ Second, it would be very difficult for outsiders such as judges or competition authorities to take rational investment decisions on behalf of the undertakings concerned. The perceived quality of investment decisions depends on very subjective preferences on what should be done (strategy), cash flow (return), and risk, and on the quality of available information. Judges or competition authorities are not better equipped to take investment decisions. For instance, this explains the business judgment rule in company law.³¹⁵ Third, the obligation to invest would be likely to cement the dominant position.

In principle, long-term supply contracts could be the cause of vertical foreclosure as their effects can be similar to vertical integration.³²⁸ The Third Electricity Directive provides that the Member States should encourage the use of interruptible supply contracts.³²⁹

In practice, however, Article 101 TFEU is not applied to vertical agreements to the extent that they do not contain prohibited clauses.³³⁰ Moreover, long contract duration can often be regarded as compatible with competition law because of its benefits. It is particularly interesting that long-term contracts can increase infrastructure investments by reducing investment risk and by making it easier to raise funding. The benefits of long-term contracts have been recognised in EU competition law.

They were recognised by the Commission in Scottish Nuclear

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