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October 23, 2001 


U.S. Power Firms Plunge Into Europe's Trading Market; 
U.K.'s NETA Rules May Set Continental Standard 



By Will McNamara
Director, Electric Industry Analysis 


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[News item from Reuters] U.S.-owned Entergy-Koch Trading (NYSE: EKT) is boosting its European electricity and weather trading business with expansion in Germany and the Netherlands. "After a successful start, we plan to substantially increase our volume of European power, power options and weather trading next year," said Uday Narang, managing director of European trading. EKT also completed the paperwork needed to start trading electricity in France and Austria, although its immediate focus would be Germany and the Netherlands. 

Analysis: The announcement from Entergy-Koch Trading that it will significantly increase its European power trading business is by no means unique. In fact, a recent scan of announcements from U.S. power firms tells a similar story. Dynegy announced last week that it is seeking acquisitions to strengthen its European operations, in an effort to "replicate its strong U.S. energy trading platform in Europe." TXU said that it expects "sharply higher profits this year" from European energy trading as its electricity trading volumes have soared across the Continent. For the first nine months of 2001, TXU reportedly traded 211 terawatt hours of wholesale electricity in continental Europe, mostly in Germany, which compared to 97 terawatt hours in all of 2000. Further still, UtiliCorp just announced that it and an unnamed financial partner will be purchasing Midlands Electricity, the fourth-largest regional electric utility in the United Kingdom, which in addition to 38,000 miles of electric distribution lines owns a 1,875-MW power plant. The unrelated announcements have a common denominator: U.S. power firms are plunging into the European energy trading market in droves, despite some inherent governmental challenges and resistance toward embracing electric competition among some European countries. A new model in the United Kingdom, known as the new energy trading agreement (NETA) rules, appear to be facilitating more efficient trade in that country and could become the standard across the Continent. 

The appeal of Europe's power market for U.S. energy companies is perhaps obvious. According to a Financial Times Energy report from late last year, demand growth for electricity in European countries over the next five years may prompt the need for an additional 69,000 MW of generating capacity to be built (an amount roughly equivalent to the generating capacity of ERCOT in Texas). In addition, like other developed areas of the world, Europe's energy consumption has grown over the last two years. U.S. power firms, who perhaps see their competitive opportunities as being rather limited in this country, have expanded operations in Europe, where electric privatization is occurring on a country-by-country basis. Consequently, the companies mentioned above join Williams, Enron, Duke, AEP, and Mirant (to name a few), which have established London trading offices. 

Moreover, many of the U.S. power firms that expand into Europe start by accumulating generation assets in the United Kingdom, as represented by the UtiliCorp and Dynegy announcements. Much of this has to do with the fact that the United Kingdom began privatizing its electric market in the early 1990s and completed the process in May 1999 (after Norway, but well ahead of other European countries). However, there is a more important reason why U.S. energy firms may be drawn to U.K. power trading, and that is related to the area's unique rules for energy transactions, which were outlined in NETA and took effect in March of this year. 

To appreciate the significance of the new NETA rules, it is important to first understand the context of the European market as a whole and the trading system that had been in place in the United Kingdom until earlier this year. The European Union has directed countries across the Continent to open their electric markets to competition. Toward this end, the commencement of competition in various European countries has included the following three approaches: 1) allowing end-users the right to select an alternative provider; 2) giving generation companies the right to use an incumbent power supplier's transmission and distribution network, otherwise known as third-party access; and 3) the introduction of energy trading, which has allowed an incumbent supplier to buy power on the wholesale market. This last point is significant, because some of the European countries have dismantled previously integrated, state-owned utilities and mandated the divestiture of generation assets. 

At the end of 2000, approximately 68.4 percent of the European Union (EU) electricity market was open to competition. Privatization has theoretically enabled European power companies to expand beyond their traditional service territories and business lines into other countries (at least those that are open). That is the good news. However, the basic problem with this approach is that the European Union did not put standardized deadlines for the transition to a fully competitive marketplace, and thus various countries in Europe have developed their own timetables. For instance, Germany is fully privatized, while France has been notoriously hesitant to provide third-party access to competitors. In practice, this often means that one country may have an extremely complex system for transmission tariffs while its neighboring country may have not developed any standards at all. The other problem is that physical interconnections between countries are often deficient, which makes it difficult to transport power across borders. As a result, wholesale competition across the Continent is considered rather heterogeneous and lacking in comprehensive trading standards. The lack of standards is particularly acute as it relates to rules and tariffs for third-party access to the national grids on the Continent. 

While these fundamental problems on the Continent are being resolved, the United Kingdom has moved ahead with what is generally perceived as a more efficient market because it offers one grid system, one balancing and settlement code, and one contract format. However, even the power trading market in the United Kingdom did not get off to an easy start. Up until March of this year, the U.K. power market operated under a pool / auction system. Under that model, generation companies offered electricity for sale, which was then pooled into an auction system where day-ahead bids were made and power was sold in half-hour increments. The model was quite significant because it was one of the first attempts in the world to create a competitive market for generation and it operated outside of governmental oversight. 

However, the pool model in the United Kingdom became fraught with problems, mostly because observers believed that excessive opportunity existed for market manipulation. Given the concerns with the pool format, the United Kingdom began to formulate new rules for power trading in October 1998, which culminated in the NETA model that started this year. The key tenets that make NETA different from the previous pool model are: 

Forwards and futures markets, which allow participants to form power sale deals using standardized contracts either on-the-day or several years in advance (as opposed to only day-ahead bids). 
More flexibility regarding the kinds of contracts that buyers and sellers can negotiate (bilateral and multilateral contracts are allowed in the United Kingdom). 
A new balancing mechanism covering ancillary services overseen by National Grid Co. (operating in a role similar to an ISO), which facilitates the various transactions to ensure reliability. 
The administration of contracts linking wholesale supplies with demand (represented by individual meters), and the threat of strict penalties for participants whose positions do not match their metered volumes of electricity. 



In a nutshell, NETA essentially sharpened the rules surrounding power trading in the United Kingdom to allow less opportunity for gaming. The system improvements have been successful, and more international power firms apparently believe that they stand a better chance of competing in the United Kingdom due to the NETA rules. Installation of the NETA system reportedly has caused a 315-percent increase in the number of contracts traded, a 25-percent drop in wholesale prices and a six-fold increase in the variety of products offered. As of early summer 2001, about 150 new participants had registered to participate under the NETA system, as compared with about 12 under the former model. 

As noted, many believe that the NETA model will become a standard for the Continent as other European countries proceed with opening their wholesale markets to competition. In addition to the U.K.'s model, there are several active trading exchanges in Europe presently, although more are expected to emerge as the market becomes more competitive. The Nord Pool, with about 60 members, organizes trade in standardized physical and financial contracts, and provides current prices on electricity in both spot and futures markets. The Dutch Amsterdam Power Exchange has about 25 members and operates a spot market for electrical power. Smaller European exchanges, offering both spot and futures contracts, include the Switzerland Exchange and Germany's Leipzig Power Exchange in Frankfurt. In the meantime, I think we will continue to see additional U.S. power firms expanding into the European trading market, and using the United Kingdom as their launch pad. 


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