1. Why introducing implicit auctions in the Central South region? Potential gains from improving allocation methods of day-ahead cross border capacity Milan 21 April 2008

2. - 2 - 2 GMEs analysis focused on the Italian borders in order to: identify the potential for efficiencies gains from the adoption of implicit auctions instead of explicit auctions as a mean to allocate cross border capacity at day-ahead stage; give, where possible, a quantitative background to assessment of the superiority of implicit auctions in short term trading, as stated by the first ETSO- Europex JWG as well as EU documents (report on the 1228 cross-border regulation); give, where possible, a quantitative background to the evaluation of the opportunity to adopt implicit auction mechanisms for each of the analyzed borders Aims of GMEs study

3. - 3 - 3 Regulation (EC) 1228/03 Regulation (EC) n. 1228/2003 (art. 2): Congestion management methods shall be market-based capacity shall be allocated only by means of explicit (capacity) or implicit (capacity and energy) auctions Both methods may coexist on the same interconnection

4. - 4 - 4 In the last years, several European institutions and associations expressed their position regarding DA implicit auction as a mean for the allocation of cross border capacity: DG for competition DG Energy and Transport ERGEG ETSO EUROPEX

5. - 5 - 5 European Commission DG for competition Energy sector inquiry, January 2007 Although explicit auctioning is theoretically and with perfect foresight an efficient mechanism and it is in practice compatible with Regulation 1228/2003, it has efficiency deficits compared to implicit auctioning especially where intraday and balancing markets are illiquid. With implicit auctions results of trade are less likely to have economically irrational use of the interconnector capacity

6. - 6 - 6 European Commission DG Energy and Transport, Report on Regulation 1228/2003 on cross border trade in electricity, May 2007 In the future, more capacity will be allocated through implicit auctions. The so-called market coupling method developed by ETSO and the association of European Power Exchanges (EuroPex) has, at the moment, the highest potential of truly integrating the European electricity market through implicit auctions at the day-ahead stage.

7. - 7 - 7 ERGEG Coherence and Convergence Report, July 2007: It is now widely recognized that for the day-ahead timeframe, implicit allocation methods are more efficient than explicit auctions and should be the target mechanism for all regions for the day-ahead timeframe

8. - 8 - 8 EUROPEX-ETSO Interim Report Development and Implementation of a Coordinated Model for Regional and Inter-Regional Congestion Management, April 2008: Implicit auctioning may be superior to explicit auctioning in allocating capacity even for immature energy markets, provided at least one of the coupled markets has a reasonable level of liquidity

9. - 9 - 9 GME has identified 4 areas in which potential for efficiencies gains may arise from the adoption of implicit auction: lower operational risks lower trading risks/costs impulse to the growth of the liquidity in local energy markets netting of the flows and more efficient use of the capacity Potential for efficiencies gains

10. - 10 - 10 7.00 1. Nomination to Terna of yearly and monthly capacity rights 7.50 2. Publication by Terna of daily ATC and opening of day- ahead explicit auction 8.20 3. Gate closure of day-ahead explicit auction managed by Terna 8.30 4. Publication by Terna of results of day-ahead explicit auction 9.00 5. Gate closure of GMEs day-ahead energy market Example: Time schedule of day-ahead auctions managed by Terna Operational risks may arise because explicit auctions at day ahead stage require in a very tight timeframe: TSOs and PXs to coordinate the functioning of the capacity market (managed by TSOs) and the energy market (managed by PXs) Operators to set up and send their bids/offers to the energy markets on the basis of the results of the capacity auctions 7.00 1. Nomination to TSOs of yearly and monthly capacity rights 7.50 2. Publication by TSOs of daily ATC for implicit auction 8.20 3. Gate closure of day-ahead explicit auction 8.30 4. Publication of results of day-ahead explicit auction 5. Gate closure of involved day-ahead energy markets Example: Indicative time schedule of day-ahead implicit auction Lower operational risks By integrating capacity and energy markets, DA implicit auctions reduce those risks

11. - 11 - 11 With DA explicit auctions, since there are two different markets for the capacity and the energy: Operators have to coordinate their capacity and energy positions. Therefore, their bidding strategy must take into account the trading risk due to the separate trading of capacity and energy Problem of asymmetry of information may be relevant, especially in presence of immature energy markets that do not have a clear price signal Operators have to bear the costs of participating to two different markets/platforms (guarantees, IT,…) By integrating capacity and energy markets, DA implicit auctions reduce, ceteris paribus, trading risks and trading costs Lower trading risks/costs

12. - 12 - 12 Impulse to the growth of the liquidity in local energy markets Experiences show that implicit auctions for the management of cross-border capacity can be successfully launched even in presence of illiquid local energy markets if at least one of the coupled market has an adequate level of liquidity. The ratio is that by coupling, via an implicit auction mechanism, two local energy markets, the liquidity of the immature market is going to increase since its participants may access to the liquidity of the more mature market: in 1998, Nord Pool, already operating in Norway and Sweden, was extended to Finland in 2006, the Trilateral Market Coupling (TLC) between France, Belgium and Netherlands was launched by launching, at the same time, the Belgian energy market The development of local energy markets brings, indeed, benefits in terms of competition and transparency

13. - 13 - 13 Netting of the flows and more efficient use of the capacity The superiority of DA implicit auction in allocating cross-border capacity, respect to DA explicit auction, relies on two main features: DA implicit auction allocates the cross-border capacity between two areas as a function of the price differential of the prices in the area energy markets. DA implicit auction enable the netting of the flows in opposite direction Therefore, the outcomes of a DA implicit auction ensure that: the net cross-border schedules go always from the low price area towards the high price area the congestion revenue calculated on the basis of price differential is the true congestion revenue, unlike with explicit auctions where, as it may turn out, there can be a congestion revenue even if there is no congestion DA Implicit auctions: are compatible with explicit auction for the allocation of longer term capacity rights (weekly, monthly, yearly products) are compatible both with a flow-based capacity model (PTDF/BC) and with ATC/NTC framework as well

14. - 14 - 14 PBPB Price DAM B Energy DA implicit auction and long term explicit auction Import from B to AImport from A to B NTC B A NTC A B PAPA Price DAM A Energy Net Export Curve A Capacity allocated with explicit auctions of long-term products and nominated Net cross border schedule PAPA PBPB Commercial schedule resulting from DA implicit auction P A * = P B * PB*PB* PA*PA* Net Export Curve B ATC B A

15. - 15 - 15 Quantitative background GME analyzed on the border between Italy and those countries with a liquid index of hourly day-ahead energy prices: France (PowerNext) Austria (EXAA) Switzerland (EEX-CH) For Italy, the price of northern zone of IPEX was considered. Inefficiencies in cross border schedules in 2007 is calculated as the estimated value of the unused cross-border capacity 1 : (NTC L H – FLOW L H ) * (Pr H – Pr L ), where: NTC L H is the hourly NTC, published by TSOs in the Auction Rules, in the direction from the lower area price to the higher area price. NTC values have been reduced accordingly to the notices of curtailment published on Terna web-site, during 2007. FLOW L H is the hourly day-ahead net scheduled flow published by ETSOVista. Pr H and PR L are, respectively, the hourly prices, respectively, in the higher and lower area price. 1 The concept of estimated value of unused cross-border capacity was adopted in the Energy sector inquiry (January 2007), by the DG for competition for calculating the inefficiency on the Dutch-German, French-UK and French-Spanish borders (see DG Competition Energy Sector Inquiry, par. II.3.5.3, January 2007)

16. - 16 - 16 The estimated value of the unused cross-border capacity represents only a proxy of the inefficient use of the cross-border capacity that could be reduced by adopting DA implicit auction. It relies on the following assumptions: demand and supply curves in the neighboring markets are, respectively, flat and rigid, i.e. prices would not change if cross-border schedules change liquidity of neighboring markets would not change (increase) in case of coupling bidding behavior of the operators would not change in case of coupling Estimated value of the unused cross-border capacity P A - P B Flow B A Flow A B NTC A B NTC B A Estimated value of the unused cross-border capacity

17. - 17 - 17 In 2007, cross border schedules on the Italian border with France, Austria and Switzerland were: 45 TWh 14% of the energy sold on IPEX (incl. OTC) 33% of the energy sold on the Northern zone of IPEX (incl. OTC) Cross-border schedules

18. - 18 - 18 Prices

19. - 19 - 19 Cross-border schedules

20. - 20 - 20 Price difference vs cross-border schedules

21. - 21 - 21 Price difference vs cross-border schedules

22. - 22 - 22 Price difference vs cross-border schedules

23. - 23 - 23 2007: prices in Northern zone of IPEX2007: net cross-border schedules Italian prices are higher most of the times, but…. …operators expected Italian prices to be always higher! Price difference vs cross-border schedules 91% of the hours: higher than PowerNext prices 99.6% of the hours: import from France 82% of the hours: higher than EEX-CH prices 99.6% of the hours: import from Switzerland 93% of the hours: higher than EXAA prices 100% of the hours: import from Austria

24. - 24 - 24 Adverse schedules and prices in 2007

25. - 25 - 25 Adverse schedules and prices in 2007

26. - 26 - 26 Estimated value of the unused cross-border capacity

27. - 27 - 27 Prices

28. - 28 - 28 In the last quarter of 2007 we find more than 80% of the estimated value of unused capacity In the last quarter of 2007 price difference changed sign more frequently! Estimated value of the unused cross-border capacity and prices

29. - 29 - 29 The analysis of the Italian, French and Swiss cross border schedules and prices highlights that: when the sign of price difference does not change (i.e. Italian prices are higher), the estimated value of unused capacity is negligible when the sign of the price difference changes more frequently (prices converge), the estimated value of unused capacity sharply arises! Is day-ahead implicit auction the solution? Other aspects should be evaluated: presence of overlapping countries raises coordination issues with coupling project in other relevant region (CWE, CEE) evolution of prices cost/benefit analysis of introducing implicit auction introduction of intraday trading could reduce the inefficiencies arising from DA explicit auction Conclusions and final remarks

30. - 30 - 30 Analyzing the schedules on the Slovenian-Italian and Greece-Italian borders during 2007, it should be underlined that: in 77% of the hours Italy imported from Slovenia in 28% of the hours Italy imported from Greece The direction of the flows between Italy and Slovenia and Italy and Greece changes more frequently than on the other Italian borders! Assuming that frequent changes in the direction of cross-border flows imply frequent changes in price differences, then efficiency gains by implementing implicit auctions may be considerable. Moreover, great benefits could be gained in term of impulse to the growth of liquidity in less mature markets Conclusions and final remarks

31. - 31 - 31 Thank You for Your attention! Gestore del Mercato Elettrico SpA Viale Maresciallo Pilsudski, 92 - 00197 Roma tel. + 39 06 8012.1 fax +39 06 8012 4524 www.mercatoelettrico.org info@mercatoelettrico.org