Liberalizing European Electricity: Impacts on Generation and Environment

Liberalizing European Electricity: Impacts on Generation and Environment

The Royal Institution of International Affairs

November 1996

Executive Summary
On 20 June 1996, eight years after the European Commission first published its intention to establish a European 'energy market', the energy ministers of the fifteen member states of the European Union unanimously agreed on a directive to open the EU's electricity systems to competition. The directive signals an inexorable process towards liberalization, but with many details left open and implications poorly understood.
Liberalization heralds big changes not only in the institutional and financial structure of the industry, but also in its technical structure and mix of generating sources. These changes, appropriately pursued, could also bring large long-term reductions in emissions of carbon dioxide and other environmental impacts.

Introduction: the 'Single Market'

In 1988 the European Commission published The Internal Energy Market (COM(88) 238), proposing to establish a 'single market' for energy in the European Community. It triggered a furore that continues to reverberate. The idea itself was hardly startling; the Single European Act of 1986 contained a new commitment to a Single Market, and energy was an obvious target. It had figured prominently in European thinking since the 1950s; indeed initial moves towards European integration included the treaties creating the European Coal and Steel Community and the European Atomic Energy Community (Euratom), both intended to coordinate aspects of national energy policies at a European level.

Over the years, however, practical implementation of these European intentions was thwarted by member governments determined to defend their perceived national interests; and a similar reception greeted the Commission's proposal for a 'single market' for energy. The Commission argued that Community competition rules should apply to all economic sectors, including electricity and gas, and called for greater transparency to clarify cost information. It proposed that independent producers be given easier access to grids, and that large users be able to deal directly with competing producers - so-called 'third party access', or TPA. However, the Commission initiative met fierce and protracted opposition. Managers of existing systems reacted to these proposals with truculent hostility. Member governments were reluctant to surrender any of their policy leverage over their national systems for electricity and gas.

Nevertheless, after the Commission's initial proposal, member governments including those of the UK, Sweden, Finland, the Netherlands, Austria, Italy, Spain, and Portugal began implementing a variety of measures to liberalize their electricity systems - privatizing state-owned facilities, restructuring organizations and institutions, allowing independent generation, and replacing monopolies with competition and market mechanisms. These measures were prompted by financial, political and sometimes ideological motives, and in response to pressure from major industries wanting cheaper electricity. Governments encouraged independent generation, and sold state-owned facilities to private investors, to reduce demands on government finances and raise funds for government coffers. They restructured organizations and introduced competition, to shake up monopolies perceived as inefficient and complacent. Some governments acted on the belief that markets are always inherently preferable to monopolies.

Thus, despite the strong opposition, the Commission and national advocates of liberalization proved tenacious and persistent, and the issue stayed on the European agenda. Eight years after the original proposal, on 20 June 1996, the energy ministers of the fifteen member states of the European Union unanimously agreed on a directive to open the EU's electricity systems to competition. The process is still in progress, but its import is clear. Where electricity systems previously operated as closed monopolies, the explicit effect of the directive will be to allow gradually increasing access, both for electricity users and for independent electricity generators, across national borders within the EU. Large industrial users will be able to purchase at least some of their electricity from generators other than their local systems; and independent generators will be able to sell electricity in competition with former monopoly suppliers. The detailed provisions are complex and arbitrary, the outcome of many compromises; and the consequences will not be immediate. Markets will be opened in stages: to users above a threshold of 40GWh/year from 1 January 1997; 20GWh/y from 1 January 2000; and 9GWh/y from 1 January 2003. From 1 January 2006 the directive will be reviewed. Only users of at least 100GWh/y are guaranteed open access; member states will decide which sectors can take advantage of the rest of the open market, as it unfolds from 22% to 27% to 32-33% in the three stages.

Even the 9GWh/y threshold represents only major industrial users such as large factories. Nevertheless, the expectation is that dismantling monopolies and introducing competitive pressures will bring down electricity prices, improve economic efficiency and benefit all electricity users. The terms of the directive are weak - 'limited in scope, weighed down with provisos and escape clauses and stretched out over nine tortuous years', according to the Financial Times newsletter Power In Europe (28 June). But the newsletter adds that 'the significance of its birth should not be underestimated. As the UK's largest consumer, ICI, said, the Directive will trigger competitive trends that will be hard to stop, forcing open Europe's often heavily bolted power market doors'.

Tentative though this first step may be, it reinforces the process of liberalization within member states, applies further pressure on recalcitrant governments and gives liberalization a European dimension. Analysts generally consider the trend towards liberalization of electricity in Europe to be inexorable. The EU directive is but another aspect of the process, albeit a significant one, lowering the barriers between national systems. The many important legal, administrative and institutional issues it raises are not, however, the focus of this briefing paper. Liberalization of electricity in Europe, both within and across national borders, in a variety of forms, will also have major implications for the longer term - for the evolution of electricity systems, for investment in electricity technologies, and for the environmental effects of electricity. Some of these implications are examined below.

Generating technologies

One consequence of liberalizing electricity is already evident: a liberal competitive context favours a different mixture of technologies for electricity generation. Electricity systems all over the world, including those in Europe, were originally established to take advantage of economies of scale for electricity generation by water power and steam power. Central-station systems have been scaled up on this basis ever since, to individual generating units of 1000MW or more, costing upwards of £2,000m and taking six years or more to construct and commission.

Financing such large installations - hydroelectric dams and coal-fired and nuclear steam-turbine plants - has been possible because the electricity systems ordering them have been franchised monopolies, whose captive customers ultimately have to pay for them. In the almost risk-free context of a franchised monopoly, electricity planners have been comfortable with time horizons extending forward 40 years. They have used very low discount rates, accepted construction times of up to a decade and amortized investments over two or three decades beyond that. The risks of getting it wrong have been borne not by the planners but by electricity users and governments. From the late 1970s onwards users and governments have been getting restless. Inaccurate forecasting and ill-judged investments by some electricity monopolies have been a salient stimulus towards liberalization.

In the aftermath of the first surge of liberalization, notably in the UK, the purported economies of scale of large conventional power stations are now in question; and two coincident developments have made the question far from theoretical. Within the past decade natural gas, cheap and abundant, has begun to pour into European markets; and the gas turbine has emerged as a clean, efficient and reliable technology for electricity generation, especially when coupled with a steam turbine in so-called 'combined cycles'.

A combined-cycle gas turbine (CCGT) plant can operate at base load, like a coal-fired or nuclear plant, but is much more _exible; it also has a lower unit capital cost. Gas suppliers have been eager to sign long-term fuel supply contracts at very attractive prices; indeed the possibility of selling the output to a long-term stable purchaser such as a CCGT plant now frequently becomes the basis for developing a gasfield or laying a pipeline. Moreover, a CCGT plant is easier to site than a coal-fired or nuclear plant; and it can be ordered, built and commissioned in three years or less. Its modular design means that much of the plant can be fabricated at the factory rather than on-site, and replicated units can be added quickly to meet demand. The smaller scale also fosters a steeper learning curve that can swiftly incorporate technical innovation. Smaller size and easier siting mean that if desired a plant can be located where its heat output can also be used, in so-called 'cogeneration', further boosting fuel efficiency.

With these advantages, CCGTs have already established a foothold on Europe's electricity systems, and their role is expanding rapidly. The most striking manifestation is in the UK, where liberalization has been under way since 1990. In less than seven years since the break-up of the previous monopoly, CCGTs have come to represent more than 20% of generating capacity in England and Wales. It seems unlikely that anyone in the UK will order any further coal-fired or nuclear plant for the indefinite future. CCGTs are also springing up elsewhere in Europe - in Belgium, Finland, Germany, Italy, the Netherlands and Portugal already, with plans for many more. The industry organization UNIPEDE anticipates more than 25,000MW of new CCGT capacity in western and central Europe between 1996 and 2000.

Further liberalization may well accelerate the process. In a competitive market-based electricity system, the traditional large-scale plant, coal-fired or nuclear, with its long construction time, its costly capital structure and its in_exibility in operation, is starting to look like a technological dinosaur. It is not an attractive proposition for independent power generation because it is difficult to finance. Without the guaranteed revenue stream of a monopoly system it is a risky investment; prospective financiers will require correspondingly high rates of return, raising the unit cost of the electricity generated and making it still less competitive. In a liberalized context other options look more enticing; they also become more feasible. Preference is likely to be given to smaller-scale modular generating units with short construction times, sited closer to users, perhaps owned by or contracted directly to them, both within and across national borders. An increasing percentage of such plants may be cogeneration plants.

Traditional large-scale generating plants already face other serious problems. Coal-fired plants raise questions about acid and particulate emissions, waste disposal and carbon dioxide; nuclear plants raise questions about safety, waste disposal and plutonium management. Both are fighting what may be a losing battle for public and political acceptability. Liberalizing electricity will increase the pressure on them, for purely economic reasons. Liberalizing natural gas, a related European policy issue, will reinforce this trend by encouraging the choice of gas-fired CCGTs for new generating capacity. In a liberalized market context, gas producers are likely to be eager to sign long-term contracts for stable supply to electricity generating plant. Strengthening the links between gas and electricity networks may offer a variety of advantages, especially as information technology eases the management of the networks. But market participants will have to beware of two pitfalls. In northern Europe peak demand for gas often coincides with peak demand for electricity; in January 1996 the coincidence came near to cutting off interruptible gas supplies to CCGTs and jeopardizing electricity supply in England and Wales. On the other hand, if gas-fired CCGT capacity on a system exceeds baseload electricity demand, some stations may have to come off line, and may have to pay for contracted gas supply they are unable to use. A CCGT, therefore, may have some drawbacks; but the balance still looks favourable - particularly when emission controls are factored in.

Emissions from electricity and heat

The largest single activity releasing carbon dioxide emissions in most of the developed world is the generation of electricity from fossil fuels. In Europe it accounts for 30% or more of carbon dioxide emissions. Along with transport, this is also the sector for which demand has continued to grow steadily. Another increasingly related activity is the supply of heat. In the UK, for instance, heat and electricity supply together account for over half of all carbon dioxide emissions. Electricity and heat can be generated in many different ways, using different primary sources and different generating technologies. Reconfiguring the production, delivery and use of electricity (and in some cases heating) offers a significant potential for reducing emissions of fossil carbon dioxide.

Apart from its economic and system advantages, a CCGT also offers environmental benefits by comparison with nuclear or coal-fired plant. It poses none of the problems associated with nuclear technology, emits no sulphur oxides or particulates and can keep nitrogen oxide emissions very low. Furthermore, natural gas yields only 60% as much carbon dioxide as coal per unit of useful energy; this advantage is enhanced by the high fuel efficiency of the modern CCGT, which therefore emits only half as much carbon dioxide as an equivalent coal-fired unit. If a CCGT is used for cogeneration of heat and power, its carbon dioxide emissions may be only a third or less of those arising from coal-based generation of heat and power separately. CCGTs tend to be preferred for cogeneration because they are relatively small. UNIPEDE foresees more than 50,000MW of electricity output from cogeneration by utilities and industry in western Europe alone by the year 2000, with expansion continuing thereafter.

Liberalization will also affect environmental performance through its impact on the overall efficiency of the system, including end uses, and the use of nuclear power and renewable sources. This impact is more ambiguous, and may well depend on how and on what timescale electricity is liberalized.

Short-term impacts on generation and emissions

In its successive analyses of energy in Europe, the European Commission projects continuing and substantial growth in electricity use, to be met primarily from centralized power sources. Its four scenarios for EU energy from 1995 to 2020, published in the spring of 1996, include an average increase in electricity use ranging from 1.0 to 1.5% per year. In this the Commission agrees with essentially every other official or quasi-official projection, not only for the EU but for the OECD and ultimately for the world as a whole. At the same time, the EU and its member states have embraced the concept of 'sustainable development' as promulgated at the UN Conference on Environment and Development in Rio in 1992, and have made commitments accordingly. Can continuing growth in electricity use be consistent with sustainable development?

Some environmentalists view liberalization with alarm. In the US, early moves towards electricity liberalization are already meeting vociferous opposition from respected environmental organizations including the Natural Resources Defense Council, which argues that market-based competitive arrangements for electricity will vitiate environmental controls. When an electricity system is a regulated monopoly, the regulator can in_uence the environmental impact of the system directly, by requiring the use of 'integrated resource planning' (IRP), 'demand-side management' (DSM) and related techniques intended to optimize resource use, enhance efficiency, support renewable energy and minimize environmental detriments. In the US this approach was beginning to achieve impressive if sometimes disputed results by the early 1990s. From the spring of 1994 onwards, however, with the emergence of moves toward liberalization, restructuring and competitive markets for electricity in the US, the role of IRP/DSM began to fade out of the picture. In a competitive market, if a regulator tries to require a particular system to undertake IRP/DSM activities that raise the price of a unit of electricity, customers will buy their electricity from a cheaper supplier.

Similar controversy could surface in Europe. How, for instance, will liberalization affect the EU's efforts to meet its commitments under the Framework Convention on Climate Change? Lower prices could increase EU electricity use, and in turn increase emissions of greenhouse gases. If so, the achievement of one EU policy objective could fatally undermine another. But a presumption of inevitable environmental detriment is premature. Depending on how it evolves, electricity liberalization could bring environmental benefits. US environmental opposition to liberalization appears to start from the premise that only a regulated monopoly system will act to benefit the environment, and only when the regulator compels it to do so. An alternative view, however, suggests that enlightened self-interest is more likely than regulatory compulsion to bring about truly sustainable activities.

Long-term impacts on generation and emissions

Thus far, in the process of liberalizing electricity, the focus of attention has been on institutional aspects, including restructuring, ownership, regulation, competition and internationalization. However, a yet more profound undercurrent is already perceptible, and gathering strength. Liberalization will also change the technical configuration of electricity systems, and thereby their environmental impact.

Throughout the past century the growth of electricity use around the world has been based on a common technical model, developed to take advantage of economies of scale in generation by steam power and water power. In this model, electricity is generated in large central stations, carried long distances at high voltages, and distributed at lower voltage through a monopoly network to users. The entire system, including the end-use equipment connected to it, functions as a single entity, carrying synchronized alternating current (AC) at tightly-controlled frequency and voltage. Keeping the system stable imposes stringent specifications on everything connected to it, and ultimate reliance on some form of centralized control, to which all participants cede precedence. The basic technical model is common to all systems, so much so that policymakers usually take it for granted. In the UK, for example, a key tenet of electricity policy since 1987 has been that a large-scale synchronized AC system, which must ultimately be subject to some central control to maintain its stability, can be reconciled with a liberalized, competitive market environment not only for a few years but for decades to come. This tenet is open to question; and some serious tensions are already manifest. Regulation remains pervasive and of Byzantine complexity. Private ownership of parts of the system confers only strictly limited rights and powers of control over operation and revenue. The regulator effectively allocates the proceeds and profits, satisfying few. What will happen after 1998, when monopoly franchises are scheduled to be abolished, is still highly uncertain, and the consequences could be startling.

Historically, both economies of scale and regulatory conditions have encouraged generation at central power stations, at efficiencies rarely exceeding 35%, rather than generation on the site of use. Tariff structures and connection charges have also discouraged on-site generation, and in any case using coal for on-site generation entails problems of storage, operation, maintenance and staffing. As indicated above, these conditions have changed. Liberalization of the system has increased the scope for on-site generation, which can also often benefit from cogeneration of heat and power, greatly improving fuel efficiency and thereby reducing environmental impact. Using natural gas makes generation at the scale of small industries or large buildings plausibly economic. Moreover energy service companies now offer to design, construct, operate, maintain and even co-finance on-site generation. In consequence, since 1990, on-site generation and cogeneration has already increased significantly throughout Europe, and the trend is continuing. In a liberalized regulatory context, on-site generation and cogeneration, not only on industrial sites but also for office blocks, hospitals, shopping centres and other concentrations of load, may become a substantial competitor for the central-station system.

Local generation of electricity for local use can also be extended to neighbouring users. In the UK, in April 1996, the government announced that from 1998 local generators would be permitted to supply up to 1MW direct to residential neighbours, and up to 100MW to industrial neighbours, potentially further improving the economics of on-site generation. In August 1996 reports revealed that many UK hospitals are considering using their on-site backup generators to sell electricity; many other sites with backup generators might do likewise. Some local generation is already delivering electricity directly to the local low-voltage distribution system. This so-called 'embedded generation' avoids the system costs and losses associated with the high-voltage grid; at the moment, however, the regional electricity company rather than the generator receives most of these benefits, a contentious point for such generators. Tariff arrangements that re_ect these local benefits could further enhance the attractiveness of local generation.

Extending these principles further may even lead to a revival of generation and distribution by direct current (DC). Synchronized AC, although technically more complex and demanding, is better suited for large-scale generation by steam or water power, and the concomitant long-distance delivery of electricity. The rise of on-site generation, however, would offset this particular advantage. Many of the loads connected to electricity systems in the 1990s actually require DC - all electronics, for example; and many other loads can operate just as well on DC as on AC. Furthermore, some of the most promising innovative generating technologies for use on-site, including fuel cells and photovoltaics, not to mention batteries, deliver DC; and wind turbines can deliver DC more readily than AC.

Such local network systems would offer higher efficiency and greater local control of electricity, including generation, delivery and use. The rapidly expanding capabilities of information technology would facilitate the process. The desire to minimize peak loads and reduce the required generating capacity would stimulate efforts to match generation to load at the highest achievable efficiency throughout the system. Local systems would offer business opportunities for electricity service companies able to design, install, operate and maintain the local system, including the end-use equipment. This in turn would provide a commercial incentive to design systems including new or refurbished high-efficiency buildings and end-use equipment, delivering reliable quality services while minimizing requirements for electricity or fuels.

Policy implications

Such technical reconfiguring would help to reduce emissions of carbon dioxide and other environmental impacts, not by central edict but as the outcome of business decisions taken for sound commercial reasons. It will not happen overnight, or even in a few years; but on a timescale of 25 to 50 years it looks not only plausible but attractive. Thus, in a liberalized market context for electricity, many of the relevant decisions will be taken by business and industry, to further their own commercial interests. However, the nature and pace of such a transition may depend heavily upon government policy, including:

the way in which continuing liberalization legislation is framed to reflect the full value of decentralized generation and encourage the activities of energy service companies;

finance and taxation regimes affecting electricity investments on different timescales;

research and technology development (RTD) and market supports to encourage continued technical advance in relevant generation technologies, including mechanisms to support currently less developed technologies such as biomass gasification and solar cells; and

measures to affect relative prices, such as taxation or tradeable emission permits, that would help to internalize environmental costs and accelerate a transition towards cleaner electricity and heat supplies.

In the longer term such developments, combined with steadily extending liberalization, would have striking implications for greenhouse gas emissions and other environmental impacts of electricity. In such liberal and decentralized systems, small gas turbines, fuel cells, photovoltaics and other small-scale modular technologies would deliver electricity to run high-performance buildings and other equipment on the same site or nearby, cogenerating heat where appropriate. Modular, diverse and dispersed small-scale generating facilities using local renewable energy sources would support the local network. Larger industrial users could select among options ranging from on-site generation or cogeneration with gas or biomass through to non-fossil electricity from remote sources across national borders or offshore. The availability and price of natural gas on such timescales is uncertain. However, because of the much higher efficiency, such a configuration need not entail much higher natural gas demand. Moreover, the gas resources ultimately available to Europe are very large. Before gas supplies are seriously constrained, technologies that currently appear limited, such as photovoltaics and remote or offshore renewables, may well be available on a substantial commercial scale.

If Europe's electricity evolves along this path, others will track its progress closely. Many other parts of the world face major problems with electricity. They may be eager to benefit from successful European experience, thus opening abundant possibilities for global commerce in innovative electricity technologies and services.

Conclusion

In the 1990s, liberalizing electricity is usually regarded primarily as an economic struggle between conflicting industrial interests and ideologies, mired in the specifics of regulatory detail and wrangles over terms of access. This paper has sought to look beyond the short term and the detail, to argue that liberalization has potent strategic implications for Europe's energy, its environmental impacts, and international commitments. Liberalization could mean the end of investment in large central-station generating plant, particularly those based on coal or nuclear power. Instead, electricity generation could become steadily more diverse, decentralized and dispersed, much of it closer to the point of use, under much more local control. Attaining optimum overall system efficiency would be both an economic and an environmental objective, with commercial benefits for those involved, not only within Europe but potentially worldwide. Developments such as those outlined above could reduce European emissions of fossil carbon dioxide from electricity and heat to a small fraction of today's levels over the coming decades, with overall economic benefit.

Electricity services are an essential feature of modern society. Achieving sustainable development, in Europe and around the world, will entail achieving 'sustainable electricity'. Contrary to the fears of sceptics, liberalizing electricity could open the way.