Enlargement opportunities

The ten new members of the European Union require more than $50bn of investment in their electricity infrastructure over the next 15 years. While this represents a huge opportunity, there are still barriers to overcome. Siàƒ¢n Green reports.

In May, the European Union (EU) celebrates the accession of ten new states to its membership. The enlargement sees an expansion from 15 member states to 25, a 25 per cent jump in surface area, and a 20 per cent increase in population to 450m people. In terms of population, the enlarged EU is the world’s largest single market.

The ten new member states are: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. Four more countries ” Bulgaria, Croatia, Romania and Turkey ” could join later this decade.

The enlargement will, say its supporters, stimulate economic growth in the region ” in particular in the new member states, which have had to implement wide-ranging economic and social reforms in the run-up to accession. Energy sector reform has been a key item on the accession agenda.

According to consultants London Economics International, the expansion marks the opening of a new era of energy industry market expansion. The new member states will require billions of dollars in new energy sector investment during the next decade, says London Economics. This means that this region could be the next major growth area for the global electric power industry.

Post accession region-wide annual economic growth rates are projected to exceed three per cent, says London Economics. This, combined with accession requirements, means that there will be numerous opportunities for energy market players looking to take up positions in these emerging markets.

“The ten new EU members need to meet EU standards in terms of energy policy,” says Bridgett Neely, senior consultant at London Economics. “The EU energy policies can be summarized in three axes; the first relates to medium and long-term energy security; the second is their environmental approach, i.e., their systems must be in line with EU environmental policies and they must start to incorporate the renewable standards of the EU. The third element relates to the internal market and the need to create more competition where possible in the electricity sector.”

The requirement for the ten new member states, and the other four countries attempting to qualify for accession, to comply with these standards translates into significant investment needs, says Neely. “Most of these countries had their electricity systems built in the Soviet era and as parts are no longer available, they cannot properly maintain them. There is therefore a need to replace a lot of these systems. There is a particularly large investment need in the transmission sector.”

The generation plants in Central and Eastern Europe historically have very poor environmental performance and are not very efficient ” for example, coal fired plants in Poland ” and so investment is also needed in this sector. “We have calculated an investment need in the region of $50bn up to 2018 between all of those countries,” states Neely. “And that is just for the generation and distribution sectors. You can add several billion more for the transmission sector.”

European expansion will bring numerous opportunities for investment
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Several countries are already quite far down the route of complying with EU standards ” notably Poland, the Czech Republic and Hungary ” and so have already seen quite a lot of electricity sector investment. Other countries, for example Bulgaria and Romania, have seen little investment so far. “However, the regulatory and legal structures in those countries are a little weaker,” says Neely, pointing to a number of potential barriers to investment that London Economics has identified in the region.

According to London Economics, companies investigating EU accession-related opportunities are finding that a variety of significant hurdles exist that prevent entry into the new markets. These include:

  • Historically low energy pricing based on government subsidies and continued political reluctance to raise prices to cover full costs
  • Inconsistent collections of payment due to lax enforcement and corruption, and a reluctance to pressure large state-owned companies
  • New regulatory risk introduced by rapidly evolving regulatory changes driven by EU, IMF, and World Bank pressure, and inexperienced and not always politically independent regulators in charge of implementation
  • Challenges of managing firms in a competitive, unbundled system without reliable historic accounting and operational data, leaving little basis for measuring performance or establishing realistic and appropriate valuations.

“What is interesting about the energy markets is that they are structured differently in each market. The rules must therefore be thoroughly understood in terms of how the investor is going to make money,” states Neely. “In terms of regulatory frameworks, all these markets have had to separate transmission from distribution, but what you have is a legacy of low utility costs, no obligation to pay bills and a barter economy, ie non-cash transactions. These transactions affect the whole energy chain.

“It’s a financial structure that’s very different and most Western investors are shocked by it, but it’s just something you have to deal with.” However, most countries have already improved their financial accounting systems, says Neely.

Another issue for potential investors is that tariffs are still to a certain extent controlled by the government and not an independent regulator. Governments are very sensitive to eliminating subsidies and increasing tariffs to reflect real costs as they fear being ousted during elections.

As these barriers area already falling, however, investors are showing a great deal of interest in the region. The specific type of opportunity will vary from country to country, but ranges from privatizations and utility franchises to joint ventures, concessions and opportunities for new build.

Several key companies stand out as being in a good position to take advantage of these opportunities, says Neely. “The American actors have obviously pulled out from an international presence, but what is striking is the big incumbents in Europe, particularly France’s EDF and Italy’s Enel. What you need is a large balance sheet to be able to support the level of investment required for making these investments.”

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