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By March of this year, EU governments were required to have adopted into national law two directives on gas and electricity contained in the bloc's "Third Internal Energy Market Package", which is designed to, among other things, make the trading of energy across borders easier and reduce transaction costs. However, the Czech electricity market shows just how far from reality a truly integrated and competitive European power market is.

The giant Czech utility CEZ - which is nervously awaiting the conclusion of the European Commission's nearly two-year investigation into "suspected anti-competitive practices" on the Czech electricity market, expected within the next few months - holds about 80% of the domestic power generation market, a level most would agree isn't healthy for competition. However, CEZ often loudly complains the relevant market to consider is not the domestic but the wider European one, where its market share is around only 3-4%. So what is the relevant market to look at?

In a report released May 30 entitled "Power Abuse", the Prague-based advisory firm Candole Partners, which counts CEZ competitors amongst its clients, attempts to answer this question by examining two main elements of electricity markets: the price of electricity and the interconnectedness of the markets. The assumption is that if prices are different between the Czech Republic and next-door Germany, and if interconnected capacity between the two countries is congested, then they must be different markets, not one "European" market.

Borderline similarities

Looking at cross-border auctions for electricity capacity, Candole found that demand for capacity is always higher than the supply, mostly five times higher on average, meaning that interconnection capacity is not satisfactory to cover this flow of power between the two countries. "To create a European market, you'd have to expand these capacities by investing significantly and lower transaction costs, including administrative barriers. The model should be Nordpool, working on the basis of implicit auctions," says Martin Bebiak of Candole, a co-author of the report.

For its part, CEZ denies there is any such interconnection capacity congestion on the borders in and out of the Czech Republic. "Clear evidence of that is the successful market coupling between the Czech Republic and Slovakia, where 99.99% of the time only one price for both markets has cleared," says Alan Svoboda, executive director of sales and trading at CEZ. "The Czech market is an integral part of the Central European market that includes also countries like Germany, Austria, Slovakia, Hungary... There are no bottlenecks that would limit import or export of electricity to/from the Czech Republic. In fact, due to these strong interconnectors it was possible last year to successfully introduce full market coupling on the Czech-Slovak border and further market coupling projects are underway on the Slovak-Hungarian or Czech-German border."

If the cross-border capacities are indeed congested as Candole claims, then prices should be different.

Looking at nominal prices of electricity over a time scale of, say, a month, there actually appears to be a high correlation between those of the Czech Republic and Germany, because prices on this scale are both affected by the same factors - GDP developments, global crisis, prices of oil etc. - and so trend together. This would lend credence to CEZ's claim that there is no congestion on the cross-border interconnections.

However, Candole argues that this gives a distorted picture, because the differences in prices are lost in the large scale being used. "However, if you zoom in and look at hourly prices, then you get a completely different picture," says Jan Ondrich, co-author of the report. "The base price of electricity is large [at around €60 per megawatt hour] but the differences are tiny but there, and the volatility of hourly prices is also large - there are a significant number of hours when Czech electricity prices are higher than in Germany, and there is also a significant number of hours when the prices are lower than in Germany."

When the data is "cleaned", what emerges is that there is very little correlation between the prices of electricity in the Czech Republic and Germany, with the correlation coefficient - a measure of the degree to which two variable's movements are associated - decreasing from about 0.9 to about 0.2, calculates Candole. In competition economics, if the correlation between two prices is 0.8 and higher, then it's likely those products exist in the same market. If the correlation is below this threshold of 0.8, then the markets are separate. "Electricity is a homogenous good and the correlation should be very high at 0.95 - it should really be the same, and certainly not at 0.2," says Bebiak.

The European Commission has set a target to achieve complete electricity market coupling by 2015, gradually bringing prices in neighbouring countries closer together. Clearly, much more work needs to be done.

Concentrated

If the appropriate market to consider is the Czech one, therefore, how concentrated is the Czech electricity market?

Employing the same methods that the European Competition Commission uses to determine market concentration, Candole found the Czech market to be one of the most concentrated in Europe - on a par with France and Belgium. One of those measures, the Residual Supply Index, shows the combined generation capacities of CEZ's competitors are unable to satisfy Czech demand. "In peak hours in winter, for example, CEZ's competitors are able to cover only around 30% of demand. As a result, CEZ is the pivotal supplier in the Czech Republic and the potential for market abuse is high," it says.

The Commission's current investigation is centred on how any "suspected illegal conduct" could comprise excluding competitors and raising prices on the Czech wholesale electricity market. And Candole's report investigates whether CEZ makes use of its dominant position to create high profit margins through the use of margin squeeze and vertical foreclosure.

Margin squeeze is where one company that is active in all levels of production increases its margins at one level to squeeze the margins in others. Candole argues CEZ makes use of its market power in the generation sector to minimise margins in the mining sector - in essence, taking the whole profit for itself. Candole also claims that CEZ is able to prevent new market entrants from entering the market - a practice called vertical foreclosure - because it is vertically integrated and so enjoys the dominant position on the most important market in the value chain, which is electricity generation.

By using its dominant market position, Candole calculates that CEZ's electricity mark-up is around 220%, significantly higher than in any other country in Europe. "German producers, who compete on an oligopolistic market, have price-cost mark-ups of around 30-50%."