The calm before the storm
Spain`s $15 billion electricity market is Europe`s fifth largest, and in 1998 grew at the stunning rate of 6.5 per cent. Its electricity industry reforms meet the typical requirements of competitive players, foreign investors are active, and a big dash for gas is gathering pace. But controversy over some policies continues, and the reforms to date may not be enough to give the country a truly competitive market.
Prospex Research Ltd.,
Until very recently, Spain`s electricity industry reforms had few rivals in Europe for their comprehensive, determined, and aggressive nature. While others struggled with basic issues such as grid access policy for competitive suppliers, Spain drew up and implemented a reform plan that could have come straight from a competition textbook.
This openness contrasts with reforms in some other European markets, where officials seem to seek guidance only from familiar neighbouring systems, or a single country anywhere in the world that mirrors their prejudices. Fundamental flaws still complicate the Spanish situation, but there are several policy moves that marked the country as one of the European Union`s more enthusiastic electricity reformers:
Privatization was chosen early on. Top utility Endesa began the decade as a typical state power group: over-manned, over-protected, and thoroughly politicised. It will end the decade as a fully private group on a commercial footing, ready and able to take on the leanest and meanest of private European players. From 1995 to 1998, Endesa`s headcount fell by almost a quarter, and restructuring has further to go.
The national grid company, REE, was not left in the hands of vertically integrated utilities, but carefully separated in operational and ownership terms. No Spanish utility can hold more than ten per cent of REE, and as a group utilities can hold no more than 40 per cent.
An independent market operator was established to run the Spanish pool, ensuring transparency and fairness in an organized market.
Prices have been cut relentlessly. The average tariff dropped 27.2 per cent in real terms between 1990 and 1998, according to utility association Unesa. Government coercion through regulated tariffs accounted for this performance, but now the market is adding to the pressure.
Market opening has been wider and faster than required. Customers accounting for 28 per cent of Spanish consumption were free to choose suppliers in January 1998, just over a year ahead of the EU requirement to open at least 26.5 per cent of each member state`s market to competition.
Reform has been accelerated to foster more competition. A new market opening timetable was announced in September 1998. It will free 8274 customers to choose suppliers, bringing cumulative market opening to 42 per cent by October 1999. This will take Spain nine per cent ahead of European Union requirements for 2003. The 2007 target for full market opening remains in place, although this final step is not required by the European Union`s electricity directive.
A slow start
Even with such a solid plan, Spain remains a controversial market. Look first at the reform acceleration. The government imposed this on utilities precisely because developments over the first six months of 1998 were very disappointing. Not a single eligible customer changed supplier. Some switching has occurred since then, and prices have been reduced by incumbent suppliers in contract renegotiations, but the free-for-all some hoped for just did not happen.
Big Spanish customers were publicly bitter about the slow start, forcing the government to take radical action. Besides wider market opening, it announced eligible customers would get a discount of Pta 1/kWh (ٔ.67/kWh) on capacity payments and a 25 per cent reduction on grid access charges in 1999. The government firmly believed that the combination of lower charges and thousands of newly eligible customers would spark real rivalry.
It is difficult to tell if the government has succeeded. Electricity contract prices are generally not broadcast to the public. Utility financial results are a poor guide to price trends since utility businesses stretch far beyond Spanish competitive power. Official Eurostat publications are not up-to-date. Prices in the pool are of little help too: very few end users buy there, and pool trends are determined by a wide range of electricity industry factors, not just what is happening in segments of the bilateral contract market.
This may be changing; pool purchases by end users and independent suppliers currently account for around seven per cent of demand, up dramatically from 1998 levels. But this percentage is still minor, and the trend is too new to be a definitive measure of the market`s progress. This leaves general comments from utilities and a few contract stories that find their way into the public domain. As of early 1999, neither indicates brutal rivalry, even if pressure is real. For all its reforming zeal, Spain does not enjoy the supply contract fights breaking out in markets like Germany.
Yet reform acceleration had a price tag: the electricity industry insisted on securitization of stranded cost payments in re-turn for wider market opening. Under Spain`s 1997 reforms, utilities were pro-mised payouts over ten years to make up for past investments which are unprofitable under competition. These payouts were subject to a number of adjustment mechanisms and an annual review. But under the 1998 acceleration programme, utilities were allowed to transfer their “right” to 64 per cent of the maximum possible payout to a special purpose company. This company will then issue bonds to investors, pass the money raised to utilities, and cover interest and capital payments through a guaranteed 4.5 per cent share of the Spanish regulated tariff for the next 15 years.
The financial mechanics here may be mind-numbing, but the point is simple: utilities get a cash pile totalling Pta1031 billion ($6.9 billion) before transaction costs, rather than wrangling with the government every year for a part of that pile. Utilities are quietly overjoyed with their victory, and the government insists the securitization deal was unavoidable, but others are furious. The president of the Spanish regulator resigned in protest in February 1999, and Brussels, which has the final say on the deal, has been notably skeptical.
It is easy to understand why. If assets really “lose” under competition, utilities need to demonstrate that there is damage. But the contract market developments covered above do not make for a fully convincing case. Nor does the operating and financial performance of the utilities: it is getting better and better, but should be set against claims that competition is hurting.
Even if competition is hurting, utilities have more than made up for this with efficiency measures. Their rising profits and surging share prices demonstrate that they are actually in top form. Utility association Unesa does point to external profit drivers like tumbling interest rates and rising diversification investments, but it is easy to suspect highly committed utility managers will find other profit drivers if these external supports are reduced.
This can be taken one step further. Whatever stranded cost policy the government manages to impose, and whatever high market opening levels it trumpets, the Spanish electricity industry looks structurally incapable of delivering the kind of competition one sees in Nordic markets. Spain has only four vertically integrated utilities, and two are behemoths. In 1998, power sales at Endesa and Iberdrola accounted for 43 per cent and 36 per cent, respectively, of Spanish demand.
Each utility is intimately familiar with the other through decades of close cooperation, which endures today in joint ownership of some of Spain`s largest power plants. Much can be made of this from a safe distance. No one in authority will ever say it, and it is impossible to prove, but some independent Spaniards and foreign cynics will suspect that this intimate knowledge is extremely advantageous to the utilities. No utility is foolish enough to start a prolonged, vicious price war that will hurt all combatants. Electricity competition`s short history is littered with examples of excessive market power, for example in the discredited England and Wales pool. Given Spain`s industry structure, similar problems may be unavoidable.
The government is not worried. It seems amazingly indifferent as to what happens at the strategic level, provided the four utilities stick to their 1996 pledge not to acquire each other. In the gas business, this means Gas Natural, which runs the industry, is fair strategic game for Iberdrola and Endesa. Any alliance with either player is hugely significant: gas-fired projects totalling tens of thousands of megawatts are under development in Spain, since the combined cycle plant is a competitive weapon and the replacement for ageing capacity. So far, Gas Natural is playing hard to get. But it should be watched like a hawk.
Repsol too should be kept under close watch. It is firmly in the orbit of Iberdrola, but is being wooed by Endesa, and may enjoy special advantages as Spain`s national oil champion. It is a 45 per cent holder of Gas Natural and a determined independent gas business builder. Heartening as rivalry between Endesa and Iberdrola over gas business convergence partners today is, the long term implications are scary. Even pointing out Unión Fenosa`s own recent dalliances with Cepsa, Spain`s second largest oil company and jilted Endesa partner, is not yet enough to allay concerns. Three convergence stories are obviously better than two, but the third is of relatively minor significance.
If industry structure is a problem, one must still acknowledge that it is not the only difficult issue, and that important changes are underway which may make the market more dynamic. One key issue is autoproducers – on-site generators who usually sell the bulk of their output to utilities under Spain`s “special regime” CHP and renewables promotion policies. Autoproducer output has soared in the 1990s, hitting 27.8 TWh in 1998, up 22.6 per cent on 1997, and equal to 16.1 per cent of mainland system needs. No prizes for guessing why. The regulated prices utilities pay to “special regime” plants are falling, but still generous. The 1998 average price was Pta9.7/kWh, which is 67 per cent above 1998 average pool prices.
This does not look sustainable. The regulator expects another 20 per cent surge in autoproducer output for 1999, but a few more years of rapid growth would turn the autoproducers into a significant financial burden for utilities, and ultimately end users. This would defeat the purpose of reform, and essentially subsidise Spanish industry for no good reason except the environmental benefits of CHP and renewables. And those benefits might be secured for less with a targeted incentive programme employing strict competitive mechanisms, such as the UK`s NFFO policy, rather than general technical criteria. This would be no concession to utilities: their “diversification” arms are actually the biggest special regime project investors in the country.
Perhaps the arrival of several new entrants will force Spain to finally address the autoproducer surge and other distortions. National Power is taking a 25 per cent stake in number three utility Unión Fenosa`s generation business, hopefully contributing valuable cost-cutting experience, and raising the pressure on other utilities. The smallest utility, Hidrocantábrico, has sealed an alliance with Eastern, the UK arm of Texas Utilities that is buying up as much of Europe as it can. This should help Hidrocantábrico achieve its ambitious growth aims, making it a threat rather than an irrelevance for the top players.
IPP giants like Enron and AES are finding it difficult to get projects off the ground, in part thanks to low pool prices, but in time they may succeed with very cheap output from big projects. Traders such as SKS, backed by Norway`s Hafslund, are also making little headway, but the need for their services may be better appreciated as the market becomes more familiar.
In sum, there is every reason to hope that Spain will, by 2001, be a hotly contested market, rather than an oligopoly. But there is no reason to expect that to happen until Madrid officials start acting on what they can learn from the newest and most controversial competition theory textbooks, which deal not with the broad lines of reform policy, but the practical intricacies of market power and regulating gas-electricity convergence. It will not be fun; utilities will mount a furious and in parts very convincing case against change, and project confidence will evaporate until the new regime is in place.
But these are small prices to pay if Spain is to fulfil its potential as one of Europe`s most interesting and important competitive electricity markets. And the prizes are attractive indeed: cheap power for Spanish industry, which is essential in an integrated European market, and transparently strong utilities ready to tackle the rest of Europe, some corners of which are badly in need of some Spanish zeal.
Figure 1. Plenty of room for gas-fired power to grow. Spanish utility production mix, 1998
Figure 2. Autoproducer output and grid sales, 1990-1998
Figure 3. Special regime capacity, 1998, % of total and MW