Network Codes - The effect on the wholesale market electricity market Charles Whiddington & Mauzima Bhamji November 2014

A look back to the origins of the single energy market 1990s: When most of the national electricity and natural gas markets were still monopolised. The European Union and the Member States decided to gradually open these markets to competition. First Energy Package - adopted in 1996 (electricity) and 1998 (gas). Second Energy Package - adopted in 2003. 2005 - The European Commission launched an inquiry into competition in gas and electricity markets. To tackle the problems identified in the course of the inquiry, the Commission is pursuing individual cases under competition rules (anti-trust, merger control and state aids) and started work on the Third Energy Package. 2011 - Heads of Member States have set a target date of 2014 for a fully functioning electricity market. The Third Energy Package (Directives 2009/72/EC and 2009/73/EC and the related Regulations) is the cornerstone of the integration of the gas and electricity markets.

A look back to the origins of the single energy market The Third Energy Package is triggering far-reaching reforms to create a single European energy market, the cornerstones of which are: Ten-Year Network Development Plan (TYNDP), the first edition released in 2010. Network Codes to achieve the target model. The Network Codes form annexes to the Electricity Regulation (718/2009) and will be directly applicable in all Member States. Governments are required to ensure national legislation does not conflict with European legislation. Alongside this there is a “bottom-up” integration via the regional initiatives: In 2006, the European Regulators Group for Electricity and Gas (ERGEG) launched seven electricity Regional Initiatives (RIs), aimed at bringing together National Regulatory Agencies (NRAs), Transmission System Operators (TSOs) and electricity market participants in a voluntary process to advance electricity market integration on a regional basis.

What is a network code?

Just the beginning The current drafts of the Network Codes is the first step to a single energy market. Jean-Claude Juncker’s mission letter to Alenka Bratušek emphasised the importance of the single energy market: Completing the internal energy market, by connecting infrastructures and engaging with regulators and stakeholders at national and European level in order to improve, reinforce and fully apply EU legislation in this area. Increasing competition should help drive down costs for citizens and businesses and boost growth. Who is Alenka Bratušek ... and why is her appointment important? Vice President of the Energy Union

Overview of current & future network codes Requirements for Generators (RfG) Demand Connection (demand side) (DCC) HVDC Connection (HVDC) Operational Security Network (system security) (OS) Operational Planning & Scheduling (planned outages) (OPS) Load Frequency Control & Reserves (assessing adequacy)(LFCR) Operational Procedures in an Emergency (EP) Capacity Allocation & Congestion Management (day ahead/intraday & capacity calculation) (CACM) Forward Capacity Allocation (long-term timeframes) (FCA) Balancing Network Code (system balancing) (EB)

Key concepts of the single electricity market Electricity can be traded across different time scales. The key ones are: Day-ahead - the most important gate closure for trading. Intra-day – serves as an adjustment after day-ahead gate closure. Real-time balancing - after gate closure, when all trading ceases among participants, the TSO takes full control of the power system and corrects any imbalance created by the difference between supply and demand in real-time. Transmission capacity is a constraint on what can be traded. When the desired transfers of electricity exceed the transmission grid capacity, congestion occurs. TSOs use special methods and trading mechanisms to alleviate congestion and manage network constraints. For example; transmission capacity calculation and allocation methods, dispatch optimisation decisions, redirecting electricity flows between congested areas either by direct trading (counter-trade) or splitting same-priced congested areas into two or more areas with different prices (market splitting) or even curtailing electricity flows. Before market coupling - cross-border trading as transmission capacity was bilaterally agreed exclusively between the zones where trading takes place, without considering interactions with neighbouring systems.

Key concepts of the single electricity market Harmonisation of transmission capacity calculation and allocation methods by using a Common European Grid Model (CGM) to maximise the capacity available to the market. The increased interconnection capacity could then be used for balancing purposes. Day-ahead electricity markets integration through a market coupling mechanism: The aim is to lower average prices across the EU by synchronising day-ahead operations of different markets in terms of gate closure times, operational procedures, type of products available for trading and transmission capacity allocation across borders. Enables joint market clearing, making available all cross-border supply and demand bids for trading at the same time, which can be matched automatically with the available crossborder transmission capacity. Transmission capacity can be procured implicitly, together with energy trading, as opposed to traditional explicit auctions. Parties can access cross-border energy and capacity without having to procure them from separate markets.

The EU target model

The target model For their capacity calculations, TSOs need to apply an available transfer capacity or a flow based method. For the forward interconnection capacity market, capacity is allocated by means of explicit auctions (the situation where transmission rights are sold separately from the market place where electricity is auctioned off) of long-term transmission rights either financial (FTR) or physical (PTR) with “use-it-or-sell-it” clauses, with the objective of giving participants an instrument to hedge against day-ahead congestion pricing. In FTR auctions, the TSO sells financial contracts that entitle the holder to receive, over a given period of time, the price difference between two interconnected countries, generated by the congestion. The holder does not have any right to physically use the interconnector. In contrast, in PTR auctions, the TSO sells to market participants the right to inject power in a country and to (simultaneously) withdraw power in another country over a given period of time. Under the “use-it-or-sell-it” clause, capacity holders must either use or sell the capacity in the day-ahead market.

The target model For the day-ahead interconnection capacity market: capacity is allocated with implicit auctions (auctioning of transmission capacity is included in the auction of electricity) via price coupling (European Price Coupling). Market participants of different areas only have to bid for electricity on their power exchange. The power exchanges share the bids and calculate the allocation of the crossborder transmission capacity that minimise the price difference between the areas, using a common allocation algorithm. The Northwest European (NWE power markets as well as Poland) day-ahead power market was launched successfully in February 2014. For the intra-day interconnection capacity market: capacity is allocated simultaneously with energy, under continuous trading. The purpose is to allow for faster adjustments within the day of operation. In continuous trading bids and offers can be submitted to power exchanges at any time. This is intended to provide greater flexibility for participants to perform short term adjustments. A functioning intraday market will increase the efficiency of the balancing market. It will allow better deployment of resources if unit commitment can be rescheduled and balancing resources used only when needed.

Impact on financing - day-ahead The main objective of the optimisation is to maximise the total economic surplus of all participants and to determine the flows that lead to a levelling of prices across markets. Cheaper electricity offered in one country can meet demand and reduce prices in another country. Prices will level out whenever there is sufficient transmission capacity. When congestion occurs, prices between zones differ and the mechanism ensures that power flows from the lower priced zone. The efficiency of the mechanism is revealed by an increasing price convergence between market areas. Alternative view - price convergence within the NWE region has been declining over the past two years, showing that market coupling has only a limited effect on spot prices, which are ultimately still decided by demand and supply fundamentals in a specific market. "All in all, the integration under the wider NWE coupling initiative will probably bring markets closer together, but the fundamental situation in each of these countries remain essential for the future convergence of prices," GDF Suez Trading analyst Paul Raymond told Platts last week. Has the benefit of optimising trading opportunities for power plants that would otherwise face shorter running times due to wind energy integration, giving them access to trade in different zones and markets. Energy can be and is procured across larger geographical areas. For wind – generation can be more easily aggregated.

Contracts in the market Long term contracts – regulatory limit on long term contracts to ensure liquidity. Sector specific regulatory constraints (e.g. only 80% may be long term). Competition law (contract scope, duration and nature, foreclose the market). EDF long term contacts case that was settled via commitments. Financial trading instruments: Forward market. Day-ahead market. Physical contacts: Intra-day market. Balancing. Secondary market – “Use it or Sell it” requirements. Compliance with financial regulations – Mifid (I & II), MAD, EMIR, Remit etc.

Project financing According to the European Commission, around €200 billion of European energy infrastructure investment is required by 2020, of which €140 billion relates to electricity transmission, storage and smart grid applications. Project financing decision making - the risk and reward profile that will: pay the costs and expenses of operating and maintaining the project; repay the lenders; and provide a return to the borrower and its investors. The Target model effectively aims to exert a downward pressure on wholesale electricity prices. In an aggressive trading environment in which some projects may not be able to compete effectively. The Target Model effects the financing the risk and reward profile.

Contacts Charles Whiddington Mauzima Bhamji Partner - London E: charles.whiddington@fieldfisher.com T: +44 (0)20 7861 4966 M: +44 (0)7725 052575 Mauzima Bhamji Senior Associate - London E: mauzima.bhamji@fieldfisher.com T: +44 (0)20 7861 4142 M: +44 (0)7714 140892