Hedging Strategy and Electricity Contract Engineering - IFOR

10 The electricity market
dynamic is investigated in Chapter 2.9.
2.2. Liberalization of the electricity market
Traditionally, centralized regulation of the electricity supply industry was
considered necessary to ensure security of supply and efficient production.
Efficiency was achieved through economics of scale. The electricity industry
was characterized by a highly vertically integrated market structure with little
competition in the potentially competitive segments of the market, with the
market defined as a national electricity market. It used to be assumed that
electricity generation, transmission, distribution and supply enjoyed significant
vertical economics that would be lost if the functions were placed under
the control of different companies. Such economics arose from the reduced
transaction costs, the improved incentives to invest in specific assets that
would not be subsequently held-up, and the advantages of coordinated supply
and demand side planning [BV99]. In particular, it was almost universally
observed that generation and high voltage transmission were integrated within
the same company, as were distribution and retailing. However, many countries
have during the last decade restructured and deregulated their electricity
industry to introduce competition. In particular in the European Union, many
countries have already liberalized their electricity markets. 3 In 1997 the
Directive 96/92/EC on the Internal Market in Electricity came into force,
providing for a phased up opening of electricity markets to competition.
The Directive established common rules for the generation, transmission
and distribution of electricity and prescribed a separation of the monopoly
elements of the business from the potentially competitive segments so that
controllers of the monopoly parts are unable to use their market power to
abuse their position in other stages of production. The Directive introduced
competition at the wholesale and supply level of the industry and marks
the last step to the liberalization of the electricity sector in the European Union.
One can ask oneself what initiated the wave of deregulations in the electricity
markets worldwide in the last ten years or so. One reason why this process
3 For example, competition was introduced in England and Wales 1989, in Norway 1991,
in Sweden 1995, in Finland 1997, in Spain 1999 and in Germany in 1999.