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As we await the European Commission's report into CEZ's alleged anti-competitive practices, Prague-based advisory firm Candole Partners has helpfully published a report entitled "CEZ Unplugged" in which it sets out to analyse and explain the structure of the Czech electricity market, and in doing so dispels some myths it claims are perpetuated by the powerful utility's supporters in politics, the media and financial circles.

Candole believes it is filling a gap in the market. Consultancy reports on the Czech automotive, retail and property markets, for example, are legion, but those on the Czech energy market are noticeable for their absence. "People in Germany and France actually write knowledgeably about their domestic electricity markets, whereas here they don't. All the people who know or should know about the potential for market abuse here are afraid of saying so publicly," says Jan Ondrich, author of the report. "We don't work for CEZ, while we have worked for several energy firms across Europe like Fortum, though we don't spare anyone in this report."

The main chapter of the report is devoted to analysing the structure of the electricity market in the Czech Republic and in the EU as a whole to dispel the notion, oft-repeated by CEZ, that there exists a competitive market on the continent and on that market it's a price-taker, ie. one whose buying or selling transactions have no effect on the market, with no dominant market power.

Yet numerous studies over the past few years, not least those from the European Commission itself, conclude that the European electricity market is not perfectly competitive but oligopolistic in structure, meaning it is dominated by a small number of sellers. This is reflected in utilities' ability to generate profits well above their marginal costs - the cost of producing one more unit of a good - which they wouldn't be able to do if they operated in the perfectly competitive market claimed by CEZ and others. Furthermore, in a perfectly competitive market there would be only marginal differences between prices between countries, which certainly isn't the case (see table).

Retail electricity prices to industrial and domestic consumers in H1 2009. Source: Eurostat, Candole Research

A study by the consultancy London Economics found that concentrated markets like the electricity markets of EU states - CEZ has about 80% of the domestic Czech generation market - tend to produce the high mark-ups over competitive prices that we witness today. So that in Germany, which has one of the EU's least-concentrated power markets, the average price-cost mark-ups were 15%, whereas in France, where utility EDF is very dominant, there's average mark-ups of almost 150%. "If German companies can earn mark-ups over what would have been a competitive price, then surely CEZ, which operates in one of the most concentrated markets in Europe, is able to do the same. And, if not, then their managers are not doing their job," says Ondrich. "European prices are a product of oligopolistic market structure rather than perfect competition."

CEZ argues that its dominance on its home market is not an issue, as the market one should look at is the wider European one. Eva Novakova, spokesperson for CEZ, told bne when the European Commission raided its offices at the end of November, that: "The EU single market is not restricted by borders of the individual countries.... On the relevant [EU] market, the CEZ Group market share is around 3-4 %."

Yet the market is most certainly restricted by borders, since there exists only a limited amount of interconnector and transmission capacity between EU states and these interconnectors tend to be congested, meaning demand for capacity far exceeds supply of available capacity. Citing data from the Central Allocation Office (the agency that organises joint auctions of interconnector capacities for Germany, the Czech Republic, Poland and Slovakia), the report shows that demand for interconnector capacity for 2010 typically exceeded by 5.5x the offered capacity in annual auctions. "At the Czech-German border, demand was approximately 5x higher than available capacity, so of course at auctions the price goes through the roof," says Ondrich. "Given incumbents' power, they usually corner the bulk of the interconnector capacity and then may or may not use it - this needs to be investigated."

Peerless

Assuming, then, that CEZ is not a price-taker on a competitive market, the report goes on to look at how the Czech utility compares with its regional peers - Finland's Fortum, EDF, Germany's RWE and E.On, and Poland's PGE - in terms of its operations, profitability, financial strength, efficiency and valuation.

On profitability, CEZ's operating margins during the latest fiscal year were the greatest at 35.27%, more than twice the average of the peer group. But what makes this level of profitability so remarkable is that CEZ is the only one whose profitability is in the same league as that of second-place Fortum. The Finnish utility is able to achieve such juicy margins because it generates half its electricity from water, which means it has almost zero variable costs, whereas CEZ generates more than half its power from coal, which of course has much higher variable costs. Imagine what its margins would be if it had a generating structure more akin to Fortum's. Furthermore, CEZ manages to achieve its high profitability despite having the second-most bloated workforce - the number of CEZ employees needed to support 1 megawatt (MW) of installed capacity is 1.9 while the range of its peers is 0.9-1.5.

Looking at return on equity (ROE), which measures a corporation's profitability by revealing how much profit a company generates with the cash that its shareholders have invested, CEZ has the highest in the peer group and does so with very little leverage. This means that its ROE could have been even higher had it used more debt. However, CEZ's ability to run its assets efficiently is not much different to its peers. This implies that rather than superior management, CEZ benefits disproportionately from the market structure and its legacy generation fleet, particularly the decisions in the 1990s to finish the construction of the nuclear power plant in Temelin - which together with the older nuclear power plant in Dukovany generate the cheapest electricity for CEZ - as well as to create a vertically integrated firm with coalmines bundled into the structure. This dovetailed nicely with Germany's decision to put a moratorium on the construction of new nuclear power plants and to rely on generating more electricity from gas-fired plants, which have a higher variable cost of production. Given that Germany is the "price-setting market" for the Czech Republic through the two markets' interconnectedness, CEZ has managed to raise its prices toward German levels - Czech household and industry electricity prices are significantly higher than the EU27 average and second only to the most expensive in Candole's sample, Germany - even though CEZ has some of the cheapest costs of production. "Had Germany generated more of its electricity from nuclear rather than gas-fired plants, CEZ wouldn't have been able to earn such a significant mark-up over its marginal costs," Ondrich says.

The problem going forward, the report argues, is that CEZ's future profitability depends on the efficient execution of its capital expenditure plan. But with CEZ management showing little aptitude for efficiently spending investors' (and taxpayer) money and the government exhibiting a "cavalier approach to scrutiny of the management it appoints," the risk is high that CEZ management will be tempted to dilute shareholder value while executing the capex plan.

To fix the accountability problem, the report concludes the government should list 100% of CEZ shares, instead of the current shareholder structure that has the state owning the majority with around 63%. This would make the authorities less willing to protect CEZ and more likely to demand public information, including whether it abuses its dominant position, while a greater number of shareholders would be able to hold the management accountable for value-diluting decisions through the supervisory board. "Rent-seeking behaviour and wasteful spending would become the shareholders' problem, not that of Czech taxpayers, who today implicitly underwrite CEZ through the state's shareholding," says Ondrich.