Spain: catching up with liberalization

Europe is running at different speeds when it comes down to implementing EU directives. This certainly holds for the directives regarding energy market liberalization. The UK and Scandinavian countries started to reform their energy markets towards competitive models in the 1990's. By implementation of the EU directives written in the late nineties, most other countries followed in 2000 - 2003. But some countries lagged behind. And these are not only countries that have only recently acquired EU membership. In the French electricity market, almost every consumer is still buying energy in a regulated market. The EU is struggling with the French government to force them to embrace energy market liberalization. In Germany, the government waited until 2007 before passing a law that organized third party access to the grids by regulating the grid fees.

I have spent the past week in our office in Spain, another country that was slow in implementing energy market liberalization. For years the Spanish energy legislation entailed a double system where regulated tariffs co-existed with open market prices. When the tariff was lower than the open market price, consumers switched to the regulated market, when the open market was dropping below the regulated level, they switched to those lower open market prices. The result was that the regulated tariff acted as some sort of upper level above which open market prices never rose much. Spanish power consumers spent a comfortable time under this umbrella and didn't have to develop the sort of purchasing practices that became common in other countries, such as buying electricity in tranches.

In 2008 the Spanish government (forced by the EU) banned the regulated tariff system. Until now, the Spanish power prices haven't shown the sort of volatility that other countries have seen in the past year. The economic crisis, which hit this country particularly hard, is of course an important reason for that. Power demand in 2009 is down 5% compared to 2008. But it is not the only reason. The large Spanish utilities seem to be still in the process of fully implementing the approaches that utilities in any other open market embrace, namely:

1. In the wholesale market: marginal cost pricing. With 55% of all electricity produced in conventional thermal power stations, you would expect the prices of coal and gas to have much more impact on Spanish power prices than we currently observe.

2. In the retail market: back-to-back pricing, i.e. daily adjusting the fixed price quotes to the level of the wholesale market prices. There is a parameter for the Iberian wholesale power market, namely the Omip futures exchange (http://www.omip.pt), but liquidity at this exchange is still very low. And what is worrying is that prices often don't show any changes at all for many days in a row. The traditional suppliers often claim that they still set their fixed prices independently of the Omip price level and that they are based on the underlying total cost structure of their production assets. In reality, this is not completely true. Retail fixed prices for Spanish power are now cheaper than a few months ago, which is in line with the Omip evolution. If we compare the fixed price quotes that we get to Omip price levels over a longer term, we see a good consistency. It is therefore safe to say that the Omip, even if trading on it is very thin, is already acting as a sufficiently reliable benchmark of Spanish power prices. But still, the Spanish suppliers are not (yet) daily adapting their retail prices to the wholesale market. If the Omip price goes up by 5 euro in a month, you will see that the fixed price quotes go up by about the same amount. But is not like in many other countries where any 1 ct change of wholesale power prices is immediately reflected in the retail prices offered to industrial consumers.

If I were a large consumer of electricity in Spain, I wouldn't bet that this situation will last forever. I know of no fully liberalized electricity market on this planet where wholesale power prices are not set by marginal cost pricing. And if sales departments of utilities sell prices in the retail market below the level that they could get in the wholesale market, they will get into trouble with their superiors sooner or later. I really believe that is just a matter of time for Spanish power consumers to suffer the same amount of volatility as their counterparts in other countries with a well-diversified power production park such as Germany. The peaks might continue to be less high, due to the availability of relatively cheap gas formulas in Spain.

With the products that Spanish power suppliers currently offer, it will be very hard for industrial consumers to protect themselves against that volatility. A year ago, we starting asking Spanish suppliers for tranche model contracts, with the possibility of fixing the electricity price for a yearly volume at different moments so that we could spread the risk of the price fixing decision. They looked at us like we came from another planet. Some of them even argued that Spanish electricity buyers would never buy in such ways. Due to our insistence, a client of ours recently signed such a tranche model contract with a large Spanish utility. And most of the other utilities are starting to offer similar products. So we could say that Spain is catching up, but is still far from where it should be. Price premiums for such products are still high, the service level for fixing the prices for the tranches is not what it should be and other conditions remain a source of much discussion. But at least, the first step is taken, and the fact that there is competition for offering such products, makes us hopeful for the future.

This is also a good thing for the gas consumers in Spain. The Spanish gas market isn't much different from the gas markets in most other European countries. The gas price is linked with a formula to oil prices. The only difference is that we often run into formulas with lower slopes, meaning that the prices don't rise so quickly with a rising oil price. But in Spain, like in any other country, the price of the gas will rise if the oil price continues its current uptrend. In those other countries, consumers will be able to hedge that risk by swapping the oil-indexed price for a fixed price. Most European gas suppliers have developed excellent services for such swapping activities. In Spain, up until now, gas suppliers were reluctant to do so. Some Spanish suppliers bluntly answered that we could contact banks to give us hedging services. But we prefer to do the hedging with suppliers for a multitude of reasons, such as accountancy, volume risk, premium issues, credit, etc. In the past year, the discussions that we had with Spanish gas suppliers regarding such hedging services were extremely frustrating. Now that Spanish power suppliers start to develop this part of the energy supply business, we are hopeful that their natural gas branches will follow suit.

E&C's Barcelona office