Organizing the electricity industry

June 07, 2021 Energy

The proposed reorganization of the energy giant EDF has sparked a media debate in France on the organization of the electricity industry. Everyone has their own proposals. Even though, considering the specificities of electricity production and consumption, no industrial structure is ideal, not all options are equal.


Market and common good

The physical laws of powering our residential, commercial and industrial facilities are well established and taught in engineering schools around the world. However, the institutional rules that best frame the relationships between the players in this industry are far from being stabilized. The current debate on the Hercules project, which was renamed Grand EDF, is a case in point. The interminable negotiations between the European Commission and the French government on the reorganization of EDF have at least the merit of drawing the attention of the French people to the organization of this essential sector. Experts, politicians, trade unionists and former EDF employees are giving their opinions in the press. A recent collective article published in Le Monde is particularly virulent against the opening to competition. The authors state that electricity provision should not be left to the market. For them, electricity is "a common good" that the climate emergency requires us to bring back into the fold of the State. This solution is only the classic expression of the centralist ideology for which only the political elites know the means to satisfy the citizens. At the other end of the spectrum are the ultra-liberals who swear by the organizing capacity of markets in the service of collective intelligence. For economists specializing in Industrial Organization, the solution depends on the characteristics of the products, the needs to be satisfied and the technologies available.


The product, its demand, its supply

First, let us note that electricity belongs to the category of private goods: when a kilowatt-hour is consumed, it is no longer available for other consumers. In order for the level of activity to be efficient, the consumer must therefore pay for the kilowatt-hours he or she takes at a price that covers the cost of making it available. In this respect, electricity differs, for example, from climate protection or good air quality, which are common goods produced by the energy transition and for which the public authorities must fight against the individual temptation to play free rider. As far as demand is concerned, it should be remembered that electrical energy is not a final good. It is only useful if equipment is available to transform it into light, heat, cold, motive power, etc. On the supply side, it is necessary to start by transforming primary energies (sun, wind, coal, water, uranium, ...) into electrical energy, then, as this energy cannot be stored, to transport it to the places of consumption by a physical connection, and finally to sell it (thus to count, invoice and collect) to the final consumers.

The construction and operation of the various pieces of this technological jigsaw puzzle can be organized in many ways: entrusting the entirety to a single company or multiplying the number of players, having some build and others operate, separating the upstream (production) from the downstream (supply), distributing the roles between private players, public players, and private-public partnerships, creating markets for wholesale, retail, capacity, pollutant emissions, etc. And who should guarantee the permanent balance of a system where a non-storable product circulates, invest in interconnections, organize the markets, fight against energy poverty, and develop clean technologies? In fact, the history and geography of the electricity industry show that almost all possible combinations have been or are being experimented with.


Regulation of network industries

In all network industries, there has been a trend for more than 30 years to separate the segments where it is less costly to have a single player (transmission and transportation infrastructure, system organization) from those where several agents can profitably coexist (generation and retail). For electricity, as for other network industries, the principle of competition is based on the distinction between the infrastructure supervised by an independent entity on the one hand and, on the other, the users of the infrastructure subject to the rules of competition. The network is an essential common good whose management and access terms must be controlled by the public authorities. Users produce and consume the goods and services exchanged through the network. Their activity can be organized within competitive markets as long as their access to the network is based on fair and transparent rules.

In the case of electricity, this implies entrusting the control and management of transmission and distribution infrastructures to either a public operator or a regulated private operator. On the other hand, the production and supply of electricity must be open to new entrants, especially since there is a sustained activity of innovation, the trend is towards the scattering of production units using renewable energies, and widespread digitalization facilitates the coordination of these units. This part of the edifice is based on two sets of markets: (i) wholesale markets where electricity producers and suppliers exchange kilowatt-hours at spot prices, forward, over-the-counter,...; (ii) retail supply markets where suppliers sell to consumers the electrical energy acquired in (i), and possibly services. The network operator is responsible for the transit of the contracted volumes on its lines and for charging for their use to cover its costs. 

It should be noted that this organizational model does not preclude intervening both upstream as a producer and downstream as a supplier, as long as this does not alter the proper functioning of the markets. Nor does it prohibit the State from participating in the financing of technologies and production equipment if this does not distort competition. And the State has good reasons to intervene, for example to support the energy transition. It is not a question of abandoning electricity to the markets, but of exploiting their advantages by regulating them. Among these advantages, we should note the permanent questioning of players who tend to fall asleep on acquired positions and the production of value indicators, prices, which reflect production costs, including climate and environmental costs. 


Back to France

Since the first Directive (1996) on the liberalization of the European electricity industry based on the principles outlined above, France has suffered (in the eyes of the European Commission) from two "handicaps":  first, it has large hydroelectric reserves and a strong nuclear industry, both of which are inexpensive and not very polluting, and second, the company that controls these production capacities is majority-owned by the State. Regarding the first point, the Industrial Organization argues in favor of a small number of players, or even one, for reasons of economies of scale, security and learning effects. There is thus a conflict with the point of view of the Community authorities, which, except for the natural monopolies of transmission and distribution lines, swear by competition between players that are small enough not to alter the functioning of the markets. But, as it happens, it is not in the DNA of a state-controlled company to abuse its position to reap profits, and if it succumbs to the temptation, the profits generated will, at worst, be distributed in the form of dividends to the owners, and therefore to French citizens. For more than twenty years, these two "French exceptions" have poisoned relations between Paris and the Directorate General for Competition in Brussels, which, as its name suggests, does not like large companies, even if they are publicly controlled. By contrast, everything is going well on the transmission (RTE) and distribution (ENEDIS and ELD) side. Despite some delays in the start-up, everything is also going well on the retail market, where there is a wide variety of sellers. But this last satisfaction is based on an organizational trick: the ARENH. To sell electricity at the retail level, you have to be able to produce or acquire it. EDF's nuclear power plants are required to supply up to 100 TWh annually and for €42/MWh to suppliers who do not have generation assets and wish to avoid the wholesale market when the price there exceeds the ARENH rate. For 2021, 81 suppliers came to the CRE's open window and had to be rationed, which is not surprising when both price and quantity are set administratively. EDF would like the government to increase the price, the suppliers to be allowed to buy more.   


Hercules and the tunic of Nessus

In this configuration, EDF loses money and customers in a steady stream to its competitors. This organization is all the more unsustainable as the company is heavily indebted and must make major investments. Hence the Hercules project and its three entities: a public company for the nuclear power plants and the transmission network, a private company for commercial activities, electricity distribution and renewable energies, and a third company for the hydroelectric dams. This combination has its advantages (essentially technical and financial) and its disadvantages: the grouping of distribution and trade clashes head-on with EC principles and the unions do not want this grouping to be opened up to private capital with a stock market listing. We know the tragic fate of Hercules as told by Ovid. We are now waiting for the Grand EDF version of this industrial puzzle.


Regulation vs. nationalization 

If there is at least one reason that justifies public intervention in the energy sector, it is externalities. Producing electricity deteriorates air quality and the climate, produces radioactive waste and generates industrial risks. To these environmental externalities, we must add security of supply, which can be considered a common good. Producers and consumers bear a collective loss in the event of a cut-off, but they have no individual incentive to avoid them. The presence of these externalities is not a sufficient reason to nationalize the energy sector. Economics recommends the implementation of public policies compatible with the market economy. Some of these policies already exist, such as the European market for emission allowances for the climate, and capacity mechanisms for security of supply. None of these markets is perfect, but neither is centralized management. And to quote Marcel Boiteux, "... as a means of driving the economy, imperfect competition proves to be far superior to imperfect planning... The problem of governments is therefore no longer to drive the whole economy, but to make sure that, whenever it can be efficient, competition and the system of markets that goes with it work as well as possible. "