German Utility Regulation

Europe GermanyUtilities

7 August 2003

German UtilityRegulation

Balancing the Risks

Mark C. Lewis+33 1 4495 [email protected]

Richard Smith+44 20 7545 [email protected]

Deutsche Bank AG

DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF THE BODY OF THIS RESEARCH

Emerging Themes

Germany to get an energy regulator from1 July 2004The introduction of a new regulator willend the system of negotiated third-partyaccess (nTPA) to energy networks thathas prevailed in Germany since itselectricity and gas markets were firstopened up to comply with EU directives.This has created uncertainty for investorsin E.ON and RWE, whose future profitscould be threatened by regulatory pricecuts. We analyse this threat in this report.

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Europe GermanyUtilities

7 August 2003

Balancing the Risks

Mark C. Lewis+33 1 4495 [email protected]

Richard Smith+44 20 7545 [email protected]

Germany to get an energy regulator from 1 July 2004The introduction of a new regulator will end the system ofnegotiated third-party access (nTPA) to energy networks that hasprevailed in Germany since its electricity and gas markets were firstopened up to comply with EU directives. This has createduncertainty for investors in E.ON and RWE, whose future profitscould be threatened by regulatory price cuts. We analyse this threatin this report.

Deutsche Bank AG

DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF THE BODY OF THIS RESEARCH

German Utility Regulation Emerging Themes

Companies FeaturedE.ON (EONG.DE), EUR45.36 Buy

2002A 2003E 2004EEPS (EUR) 4.26 3.26 3.48P/E 12.4x 14.1x 13.2xEV/EBITDA 7.4x 6.8x 6.4xRWE (RWEG.DE), EUR24.15 Buy

2002A 2003E 2004EEPS (EUR) 2.06 3.20 4.02P/E 17.7x 7.6x 6.0xEV/EBITDA 6.5x 5.5x 5.2x

The regulatory threat is to network-access chargesOur analysis of network prices in Germany suggests that inelectricity, prices for access to the very high-voltage (transmission)grid are in line with or slightly below the EU average, but that pricesfor access to the medium/low-voltage grid are well above average.In gas, both transmission and storage charges look above therelevant European averages. As a result, the threat posed by theintroduction of a regulator is that the new authority couldimplement price cuts to bring German network tariffs closer toaverage EU levels over time. We think that this threat is greater ingas than in electricity.

Energy regulation in Germany: a question of RealpolitikAlthough EU legislation requires an energy regulator, it still givesmember states a fair degree of discretion over deciding which bodyassumes this responsibility and what powers it should have. In ourview, the German government will take a number of political factorsinto account when making its decision and, on balance, we thinkthese factors mean that the outcome will be less negative for theGerman utilities than might be feared on purely economic grounds.

We think regulation is a manageable threat for E.ON and RWEA hypothetical analysis assuming convergence of German networkcharges with average EU price levels would require revenue reductions ofup to Euro 716m in the case of E.ON and up to Euro 563m in the case ofRWE. However, we think that tariff reductions of this magnitude couldtake up to three to five years to materialise, and that both companieswould be able to adjust their cost bases over such a period tocompensate. In short, we think the threat posed by regulation ismanageable, and we retain our Buy recommendations on both RWE andE.ON.

7 August 2003 Electricity German Utility Regulation

Page 2 Deutsche Bank AG

Table of Contents

Investment thesis .............................................................................. 3Outlook ........................................................................................................................3

Valuation ......................................................................................................................3

Risks ............................................................................................................................3

The structure of this report .............................................................. 4Section 1 Energy regulation in Germany: the European context..............................7

Section 2 The German path to regulation: Realpolitik ............................................11

Section 3 The economics of the existing industry structure and the politics .....17

Section 4 The range of possible outcomes ............................................................34

Section 5 Scope to reduce German transmission prices........................................40

Section 6 Scope to reduce other network-related charges ....................................48

Section 7 Impact of price reductions on revenues .................................................52

Summary of revenue and profit impact from network charge reductions ................56


Deutsche Bank AG Page 3

Investment thesis

Outlook

Germanys announcement of an energy regulator by July 2004 has increased theperception of regulatory risk for the German utilities.

Our analysis suggests there is plenty of scope for a new regulator to reducemedium/low voltage electricity-transmission charges, balancing power costs, back-up power costs as well as gas-transmission and storage charges. In our view, if allthese charges were to fall to the European average then, over time, revenue couldbe reduced by up to Euro 716m for E.ON and up to Euro 563m for RWE.

In reality, the key issue for investors will be to judge the magnitude and timing ofany regulatory enforced price reductions and the extent to which any revenuereductions can be offset by cost reductions. To a large extent, the magnitude andtiming of price reductions will depend on the political will to reduce electricity andgas charges in Germany.

The Monitoring Report due to be published by 31 August 2003 will no doubtinfluence the political will although our analysis of recent speeches suggests thecurrent German government appears satisfied with the results of electricityliberalisation, if not gas liberalisation, so far.

In our view, the most likely outcome is a new energy regulator formed within orunder the auspices of the Federal Ministry for Economics. At least in electricity, weexpect the new regulator will have responsibility for determining the methodologyto be used for price setting, with the companies themselves still negotiating priceson a case-by-case basis. The net result should be a relatively slow convergence ofGerman electricity network charges with European averages, allowing thecompanies the time to reduce costs and maintain profitability.

The position in gas appears more uncertain and thus higher risk for the utilities. Thismay result in faster regulated charge reductions. However, the relative inefficiency ofRuhrgas in particular, should allow E.ON the opportunity to cut costs more quickly.

Valuation

The scope for revenue reductions appears very material compared with profitability,representing 15% of 2005E PBT for E.ON and 18% of 2005E PBT for RWE,assuming alignment of German network charges with EU average price levels.However, we do not expect revenues to be cut in the first year of a new regulator,thus allowing time for cost cutting to maintain profits. We therefore maintain ourlong-term profit forecasts and valuation of both stocks.

Risks

The choice of regulator and the powers conferred on the regulator remain uncertain.The appointment of the Federal Cartel Office with an ex-ante price-setting role,although unlikely, would markedly increase regulatory risk. A critical view from theMonitoring Report when published in August should also concern investors.



The structure of this reportThis report is divided into seven main sections:

1. The European context. We begin by setting out the broader European contextin which German energy policy has unfolded over the last five years. In ourview, the key point about the EUs legal requirement that all member statesestablish an energy regulator by 1 July 2004 is that it still leaves a lot ofdiscretion to the governments of each member state in deciding on the natureand scope of the regulatory framework.

2. The German path to regulation: Realpolitik. This section reviews the GermanGovernments generally favourable attitude over the last four years towards theenergy industrys system of self-regulation through voluntary agreements(Verbndevereinbarungen), and the chain of domestic political events thatprompted the Government to set up a regulator.

In our view, the sensitivity of Green-Party members of the ruling coalition to thecharge that electricity prices have increased too much as a result ofenvironmental surcharges was the catalyst for the decision to introduce aregulator, but the legacy of a generally favourable attitude towards the systemof self-regulation remains in the Economics Ministry.

The next important step in the countdown to the setting up of the newregulatory body will come on 31 August with the publication of the so-calledMonitoring Report, a study commissioned by the Government to assess thecurrent state of competition in Germanys energy market.

However, the findings of this report will not be the sole determinant of theGovernments decision that will also depend, to a large extent, on certain keypolitical factors, most notably the importance of municipal entities in thedistribution part of the value chain and the severe constraints on municipalfinances generally in Germany today.

3. The economics of the existing industry structure and the politics.Germanys electricity and gas industries are concentrated at the transmissionlevel, but extremely fragmented at the distribution level. Moreover, thedistribution sector is highly politicised, as it is dominated by municipal-utilitycompanies (Stadtwerke) that provide a much-needed source of dependableincome to the municipal authorities given the extreme budgetary difficulties thatlocal authorities are now experiencing.

As we show by quoting at length from a recent speech given by ChancellorSchroeder, the parlous state of municipal finances in Germany is a majorconcern to the Federal Government, and we think this will be an importantfactor in the Governments decision-making process over regulation. Moreover,Chancellor Schroeder also appears very keen to ensure that the new regulatoryframework for energy is fair not just to industrial consumers of electricity, butalso to the utility companies that have to invest in the networks ensuring thatthe regulatory framework can maintain Germanys high standards on reliabilityand security of supply is another key policy priority for the Government.



4. The range of possible outcomes. In this section we examine the contendersfor assuming the role of regulator, and what the powers of the regulator arelikely to be. As far as the identity of the future regulator is concerned, we seethree main contenders: the Federal Cartel Office, the Federal GovernmentsMinistry of Economics, and the economics ministries of Germanys regionalgovernments. In our view, there is probably no single entity that can assume therole entirely to the Governments satisfaction on its own, but if it were to opt forgiving responsibility for the entire framework to one agency, then the FederalEconomics Ministry looks to us the most likely choice at present.

As far as the powers of the regulator are concerned, we take the view that theGovernment is inclined towards an ex-post system of regulation for the price-setting dimension of the regulatory framework, but that this inclination issubject to the findings of the Monitoring Report on the question of whethercurrent industry arrangements represent good practice. As we see it, there is agreater threat to this assumption in gas than in electricity.

5. The scope to reduce German prices. Here, we benchmark Germanysnetwork prices in electricity and gas against those of other EU member states.

Our analysis suggests that electricity prices for access to the very high-voltage(transmission) grid are in line with or slightly below the EU average, but thatprices for access to the medium/low-voltage grid are well above average. In gas,transmission charges look above the relevant European average.

As a result, the threat posed by the introduction of a regulator is that the newauthority could implement price cuts to bring German network tariffs closer toaverage EU levels over time. We think that this threat is greater in gas than inelectricity.

6. The scope to reduce other network-related charges. In this section webenchmark prices for ancillary services to Germanys energy networks balancing and back-up power charges in electricity, and storage charges in gas against those of other EU member states.

Again, our analysis suggests that the price levels for Germanys ancillarynetwork charges are well above average compared with those of other EUmember states, particularly the prices for balancing power and gas storage.

7. The potential impact of price reductions on the German utilities revenues.This section considers the potential impact of all our analysis on the futurerevenues of E.ON and RWE.

Our base-case analysis suggests that the introduction of a regulator couldultimately result in a reduction in annual revenues of up to Euro 716m in thecase of E.ON, and Euro 563m in the case of RWE (see figures 1 and 2).However, we think that tariff reductions of this magnitude could take up tothree to five years to materialise, and that both companies would be able toadjust their cost bases over such a period to compensate.



Figure 1: Revenue reduction to achieve EU average price level for E.ON

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Our conclusion is that the threat posed by regulation is manageable, and weretain our Buy recommendations on both stocks.



Section 1 Energy regulation in Germany: the European context

As in other EU member states, liberalisation of Germanys electricity and gasmarkets is being driven in large measure by EU directives, the most important ofwhich remain the 1996 EU electricity directive, the 1998 EU gas directive, and theso-called acceleration amendments made to these directives in February 2003.

However, although there is a clear and irreversible trend towards increasingharmonisation of energy-market policy across the EU, national governments haveuntil now retained a significant degree of discretion over the interpretation andimplementation of the EU energy directives, such that national policy responses tothem has varied between member states (Figure 3 charts the interplay of the mainEU and German policy initiatives concerning the liberalisation of Germanyselectricity and gas markets since 1996).

The EU electricity directive passed in December 1996 required member states tocommit themselves to a gradual opening of competition in supply, legally toseparate energy networks (transmission and distribution) from production, and tomake access to these networks fair and transparent.

However, the directive did not require the appointment of an independent regulatoryauthority to enforce these requirements. Rather, it allowed member states to opt fornegotiated third-party access (nTPA) or regulated third-party access (rTPA) tonetworks as they chose. Member states were required to comply with theelectricity directive by April 1998.

The EU gas directive passed in December 1998 similarly left open the choice tomember states between rTPA and nTPA to networks, while also requiring memberstates to commit to a minimum level of market opening (43%) by 2008. Memberstates were required to comply with the gas directive by August 2000.

The German response to date: the limits of ex post regulationGermany was one of the first European countries to liberalise its electricity market,opting for full liberalisation of supply in one go as of April 1998 following theimplementation of the German Energy Law (Energiewirtschaftsgesetz) that month.

However, Germany opted for negotiated rather than regulated third-party access toits networks for eligible customers, and to this day remains anomalous within theEU in not yet having a regulatory authority to oversee pricing in those parts of theelectricity value chain transmission and distribution that are network businessesand hence de facto natural monopolies. (Note, however, that electricity tariffs forresidential customers are regulated, with the economics ministries of the relevantstate not federal governments setting these charges ex ante according to a cost-plus formula.)

In gas Germany was much slower to adopt the EU directive, and it only became lawfour months ago, on 11 April 2003, when the Federal Government passed anamendment to the 1998 German Energy law. As in electricity, Germany opted fornTPA rather than rTPA in gas.

The system of negotiated third-party access to networks as it has developed inGermany since 1998 is based on private, voluntary industry agreements, the so-called Verbndevereinbarungen (the workings of which we discuss in more detail ina separate section below).



The Verbndevereinbarungen set common pricing guidelines for industry participants,but are negotiated on a case-by-case basis by the parties involved. The currentelectricity agreement (Verbndevereinbarung II+) runs out on 31 December 2003, andthe current gas agreement (Verbndevereinbarung II) on 30 September 2003.

Figure 3: Chronology of network access developments in Germany

2004

December 1996EU electricitydirective passed

April 1998German EnergyLaw passed

May 1998German VVI forelectricity agreed

June 1998EU gas directivepassed

July 1998German grid codeagreed out of VVI forelectricity

2003 2000 2001 2002 1999 1996-8

May 1999German distributioncode agreed out ofVVI

December 1999German VVII forelectricity agreed

February 2003EU amendments tooriginal energydirectives passed

10 April 2003Industry talks onGerman VVIII forgas break down

11 April 2003German Govt passesamendment to EnergyLaw

31 August 2003Monitoring report intostate of competition inGerman energy market tobe presented toParliament

30 September 2003Expiry of German gascode VVII

31 December 2003 Expiryof German electricitycode VVII

March 2000Second German gridcode agreed out ofVVII for electricity

May 2000Second Germandistribution codeagreed out of VVIIfor electricity

July 2000German VVI for gassigned

March 2002Germany achievesopt out at Barcelonasummit from EUrequirement toimplementregulatory authority

May 2002German VVII forgas signed

November 2002EU agrees toaccelerate theopening up ofenergy-supplymarkets in memberstates

March 2001First amendment toVV1 for gas agreed

December 2001German VVII+ forelectricity agreed

Q1 2004German Govt to finaliseregulatory framework

1 July 2004German regulatoryframework comes intoforce


As things stand at the moment, then, Germany does not have an independentregulator in either electricity or gas. Instead, it has a system of self-regulation basedon voluntary agreements between industry participants.

Policing these industry agreements on an ex-post basis is Germanys Federal CartelOffice (FCO). The FCO is a government-funded but independent entity responsiblefor ensuring that German business adheres to national and EU competition law. Assuch, it has a very wide brief that covers investigating and controlling the abuse ofdominant market positions across many different industries.

Under current arrangements, the FCO has the power to investigate network-accesscharges when it has grounds for suspecting that grid prices are excessive, both inresponse to consumer complaints and on its own initiative. Where its investigationsfind against the grid operator, it has the power to impose price reductions based onbenchmarking, though the system is one of relative rather than absolutebenchmarking: in order to assess whether a given grid operator is chargingexcessively, the FCO compares the grid charges of that company against thecheapest network-access price in the same category. The concept of networkcategories is designed to ensure that fair comparisons can be made.



Under the terms of the current electricity Verbndevereinbarung (VVII+), there are56 network categories, 18 for each of the three voltage levels (high, medium, andlow). Each category comprises companies with broadly similar structuralcharacteristics according to four criteria:

Population density: companies are classified according to whether theyoperate in high- (>3,500 inhabitants per km2), medium- (2,5003,500) or low-population (75%), medium (50-75%), or low (



In short, ever since the adoption of the 1998 Energy Law, network operators inGermany would appear to have enjoyed a benign pricing environment. This isbecause the ability of the FCO as de facto regulator to reduce grid prices has beentightly circumscribed by the limitations of its ex post powers (a function of thecircular methodology available to it for assessing the fairness of prices), by its ownlimited financial resources, and by the appeal procedures open to the gridcompanies against the FCOs rulings.

However, this could all be about to change.

The EU acceleration amendments of February 2003: a regulator for GermanyIn a surprise move, the German Government announced in March of this year that itwill establish an independent energy regulator beginning 1 July 2004.

Ostensibly, this announcement came in response to amendments made by the EUin February of this year to the 1996 and 1998 electricity and gas directives. Theseamendments require full competition for all non-residential electricity and gascustomers by 1 July 2004, and for all residential customers by 1 July 2007.

The amendments also require the legal separation of the ownership and operationof network assets (for transmission by 1 July 2004, for distribution by 1 July 2007),and the establishment of a formal regulatory authority with responsibility forensuring fair and transparent access to networks.

Concerning the establishment of a regulatory authority, the amendments say that:

Each member state shall designate one or more competent bodies with thefunction of regulatory authorities.

With specific regard to the competencies of the regulatory authority/authoritiesconcerning access conditions and charges, the amendments of February 2003define these thus:

Fixing or approving prior to their entry into force, at least the methodologiesused to calculate or establish the terms and conditions for transmission anddistribution tariffs.

With regard to the enforceability of regulatory rulings, the amendments state that:

Any party having a complaint against a transmission and distribution systemoperator with respect to the regulatory authorities responsible for ensuring non-discrimination, effective competition and the efficient function of a market ()may refer the complaint to the regulatory authority () which shall issue adecision.

In other words, although the acceleration amendments to the original energydirectives require a regulator, they still give member states a fair degree ofdiscretion over deciding which body should be responsible for regulating the energyindustry, and what powers it should have.

The question is, how will the German Government exercise this discretion?



Section 2 The German path to regulation: Realpolitik

The first step towards establishing a regulator in Germany following the passing ofthe EUs acceleration amendments in February of this year came on 11 April, withthe Federal Governments passing of the amendment to the 1998 Energy Law.

In addition to bringing Germany formally into compliance with the EU directive ongas, this amendment enshrined in law the existing Verbndevereinbarungen in bothelectricity and gas, but with the crucial caveat that the legal status of theseVerbndevereinbarungen rests on the general assumption (Vermutungsregel) thatthey represent good practice.

In other words, the legal status of the Verbndevereinbarungen as established in theamendment to the Energy Law passed in April would appear to be provisional onlyat this stage. The German Government will now seek to assess whether theassumption that they represent good practice is valid, and has alreadycommissioned a report by a group of academics and consultants the so-calledMonitoring Report to help them establish this.

This Monitoring Report will be published on 31 August, and will give an assessmentof the current state of competition in Germanys electricity and gas markets. Assuch, its findings will be an important consideration in the Governments decision-making process regarding the regulatory framework to be established.

A surprise moveThe announcement in March that the Germany energy industry would receive anindependent regulatory authority to oversee its functioning came as a surprise inthat the Government had previously seemed content with the system of self-regulation through the Verbndevereinbarung, at least as far as electricity wasconcerned (it would be fair to say that the Government had been less impressed bythe progress made by the gas industry towards liberalisation).

Indeed, Germany had previously blocked an EU initiative to make the establishmentof an independent energy regulator mandatory in all member states at theStockholm summit in March 2001. The draft proposal at the Stockholm summitcalled for an independent regulator in all member states with the power to settransmission and distribution tariffs but was firmly opposed by the GermanGovernment, as both the German Economics Minister at the time, Werner Mller,and even the president of the Federal Cartel Office (FCO), Ulf Bge, expressed astrong preference for Germanys system of self-regulation.

Moreover, Economics Minister Mller stated soon after the Stockholm summit thatthe rate of price declines in the German electricity market was evidence thatvoluntary self-regulation was working. One year later, at the Barcelona summit inMarch 2002, Germany was still insisting on its right to be different and achieved anexemption from the requirement to impose an independent energy regulator thatwas agreed by all the other member states.

In gas, the German Government has been more sceptical concerning self-regulation,mainly because the industry has been much slower to reach agreements onnetwork access that facilitate market liberalisation to its satisfaction. Indeed, in 2002Economics Minister Mller threatened to introduce a regulatory authority in gas inexasperation at the slow progress of talks to establish the secondVerbndevereinbarung (the first Verbndevereinbarung in gas came into force in July2000, fully two years after the first industry agreement for electricity had beensigned in May 1998).



Overall, though, it would be fair to say that the Government had, before March ofthis year, generally been favourably disposed towards the energy industrys systemof self-regulation, particularly with regard to electricity.

that creates uncertainty for investorsPrecisely because there had been a widespread perception before March that theGerman Government saw no need for an independent energy regulator, thedecision to introduce one beginning 1 July 2004 has created a lot of uncertainty forinvestors concerning the nature and scope of the framework to be established, andhence the extent to which the German utilities profitability might be affected.

In particular, there is uncertainty with regard to three main questions:

1. Which body will act as the regulator and how independent of Government will itbe?

2. Will the regulator have ex-ante price-setting powers of its own, or will it simplybe responsible for determining the methodology to be used, with industryparticipants themselves still actually negotiating the prices on a case-by-casebasis? (In other words, will Germany opt for a radical change to existing industrypractice, or simply enshrine in law with only minor modifications the currentmodus operandi?)

3. Will the same methodology be used for regulating both electricity and gasnetworks?

The current uncertainty surrounding these questions is understandable, as there isno pre-ordained answer to any of them. Regulatory frameworks vary considerablybetween countries in terms of the independence enjoyed by the regulatoryauthority, and of the way in which prices are set.

There are many reasons for such variations, but the most important one is politics.Even in the most economically liberal of regulatory frameworks (like that of the UK,for example), political considerations are always a crucial element in determining theacceptable level of profitability for a natural monopoly.

What this means is that until the German Government makes its final decisionsregarding the powers to be exercised and the price-setting methodology to be usedby the new regulator decisions that may not be taken until the beginning of 2004 it will be impossible to say for sure how the profitability of the German gridcompanies will be affected by the introduction of a regulator.

In our view, however, this does not mean that it is futile to attempt an analysis ofthe potential impact of regulation on the German utilities at this stage. Preciselybecause regulatory frameworks do not exist in a vacuum but rather reflect a givenpolitical context, we think it is already possible to discern at least the broad outlinesof what the new German regulatory authority might look like, and how extensive itspowers might be (see Section 4 of this report).



The political dimension to regulationAlthough the ostensible driver of the German Governments decision to introducean independent energy regulator is the EUs acceleration of the liberalisationprocess, we think that an equally if not more important factor is the politicalcontroversy created in Germany by the cost of balancing power supplied to the gridcompanies by the generation companies.

Here we briefly review the background to the political controversy caused by theissue of balancing power, before outlining how we think the interplay of this andcertain other key domestic political factors will ultimately determine the shape,identity, and powers of the regulatory framework to be established in Germany from1 July 2004.

The increasing burden of taxes and eco-friendly surchargesThe German Government has been a strong supporter of renewable energy in thelast few years, but the increasing proportion of German power generated fromrenewable sources has led to higher surcharges on consumers, as electricitygenerated from renewable sources is more expensive than energy produced fromtraditional fuels like coal and gas.

There are two main laws governing the use of, and payment for, renewable andeco-friendly energy:

The Renewable Energy Law of 1 April 2000. This replaced the Electricity FeedLaw, shifting the burden of subsidising electricity production from renewableenergy sources from individual companies to the industry as a whole (to ensureequal burden sharing). Under this law, tariffs for renewable energies are fixed.The Law assumes that the subsidy obligation is passed on in full to the supplycompanies, who then pass it on to their end customers in proportion to theirrespective sales.

The Co-generation Protection Law of 1 April 2002. This replaced the Law ofthe same name originally passed in May 2000. The Co-generation Law aims toencourage this form of electricity generation, and requires local networkoperators to make bonus payments to combined heat-and-power (CHP) plantsfor the energy they generate that is fed into the public grid. As with renewableenergy, this cost is ultimately borne by end consumers.

When viewed in isolation, the implementation of these laws has led to sharpincreases in the overall cost of electricity for all customer categories, and this hasbeen compounded by sharp increases in the federal and municipal taxes imposedon electricity in recent years.

According to the electricity industry association, the VDEW, the total amount ofstate burdens imposed on electricity customers in Germany will reach Euro 12.6bnin 2003, and this figure excludes VAT (Figure 4). This figure compares againstEuro 2.3bn in 1998, such that electricity customers will have to pay more than fivetimes as much in taxes and in subsidies for eco-friendly energy in 2003 than in1998.

State and regional taxes account for the largest share of the overall state burden.Total tax burdens are expected to reach Euro 7.7bn in 2003, nearly four times thelevel of 1999. The VDEW estimates that charges to be paid under the RenewableEnergies Act will reach about Euro 2.1bn in 2003 compared with Euro 300m in1998.



Figure 4: Taxes and surcharges on German electricity (Euro m)1998 1999 2000 2001 2002* 2003*

Electricity tax 0.0 2,090 3,480 4,210 4,950 7,650

Concession fee 2,000 2,000 2,100 2,110 2,130 2,140

Renewable energies act** 280 260 890 1,180 1,680 2,100

Co-generation act*** 0.0 0.0 610 990 680 690

TOTAL 2,280 4,350 7,050 8,490 9,440 12,580

% increase against 1998 na 910 209 272 314 452

Source: VDEW; *estimated; **since March 2002, before that Federal Law to promote the use of renewable energies; ***former Co-generation Act of May 2000 replaced by new Co-generation Act of April 2002

The burden for co-generation charges was reduced in 2002 compared with 2001owing to an amendment of the Co-generation Act in 2002, and the VDEW expectsthe co-generation charge to remain flat in 2003 at nearly Euro 700m.

What all of this means is that the proportion of total electricity costs billed to end usersthat emanates from direct and indirect taxes has risen dramatically between 1999 and2003. E.ON estimates that taxes and eco-friendly subsidies now account for about 40%of the total cost of electricity to end consumers, compared with only 25% in 1999.

From a political point of view, the important point about the increase in eco-friendlysurcharges is that to the extent they represent the Governments widerenvironmental policies, there is only a limited amount of pressure that even thepowerful industrial-consumers group, the Verband der industriellen Energie- undKraftwirtschaft (VIK), can put on the Government to reduce them.

However, the increasing use of one form of renewable energy wind has raisedthe price of electricity not just because it requires subsidising, but also becausewind-generated electricity is more difficult to regulate on the high-voltage grid. As aresult, it has been blamed for the sharp increases in balancing-power costs over thelast two years, and in our view this has been a catalyst for the FederalGovernments decision to introduce a regulator in Germany.

The controversy over balancing power: the real catalyst for regulation?The amount of installed wind capacity in Germany today is about 13,000MW, just overdouble the amount of 6,000MW in 1998 when the electricity market first began toliberalise. By 2010, this figure is expected almost to double again, to about 23,00024,000MW. In 2002, the total amount of electricity generated from wind was about17TWh, up sharply from the 10.5TWh generated in 2001 and the 5.7TWh in 2000.

This increasing proportion of electricity generated from wind has led to an increase inthe need for balancing power, in turn increasing grid charges as the networkcompanies have to pay the generating companies for providing this balancing power.And the increasing cost of balancing power over the last couple of years has led tointense lobbying from German industry on the Government over electricity prices.

As the name suggests, balancing power is the marginal amount of electricityrequired at any given moment to ensure that the frequency on the high-voltage gridremains within the limits required to keep it technically in balance. Mechanismshave to be established to ensure that top up energy can be provided if suppliersare short of electricity, and that spill energy can be disposed of if there is excesspower on the grid as a result of customers taking less than expected. By definition,it is generating companies who must provide the grid with this balancing power, andthey are remunerated for this.



Wind power increases the need for balancing power because it is dependent on theweather, such that its scheduling cannot be accurately pre-determined. The high-voltage grid simply has to take wind power whenever it can be generated, which isabout 2530% of the time, on average, in Germany. Because its scheduling cannotbe accurately pre-determined, it is liable to create imbalances on the grid, hence theneed for the generators to provide top up or spill services.

Industrial users have been very concerned by the rise in the balancing-chargecomponent of grid fees in the last couple of years, and their industry lobby group,the VIK, presented a complaint against RWE and E.ON to the Federal Cartel Officeon this issue earlier this year.

After examining this complaint, the FCO initiated price-abuse proceedings againstboth companies on 26 February 2003, suspecting them of charging excessive feesfor the supply of balancing energy in the RWE and E.ON network areas. The FCOstated in its press release announcing the proceedings that high fees for balancingenergy contributed to a 10% rise in fees for the use of transmission networks in2002. In launching its proceedings, the FCO also said creation of a single Germanbalancing area would reduce the overall requirement for primary and secondaryenergy (for example, owing to the effect of intermixing electricity surpluses in theRWE area and electricity deficits in the EnBW area). The FCO said that this wouldalso bring about a significant improvement in conditions for supply competition.

Interestingly, in a press release of 22 April this year, the German association ofnetwork operators, the VDN, stated that the increase in grid costs at the high-voltage level since mid- 2002 attributable to balancing-power charges was actuallyslightly higher than this, at 15%. The VDN was keen to point out that althoughprices for the use of electricity systems had decreased in underlying terms by onaverage 38% across all voltage levels, these decreases had been virtuallycompletely offset by the increase in balancing charges, so that grid prices overallhad fallen by only 1% over this period.

At the same time it was lobbying the FCO, German industrial consumers haveconsistently made representations to the Federal Government over the last twoyears about the high costs incurred as a result of eco-friendly surcharges. This led toincreasing pressure on the Environment Ministry, in particular, to exempt certainlarge industrial users from the requirement to buy wind- and bio-mass generatedpower.

However, the Environment Ministry has been keen to downplay the role ofenvironmental subsidies as an explanation for rising German electricity prices, andhas put most of the blame for higher industrial prices on the utility companiesinstead. On 3 March, for example, the Environment Minister, Juergen Trittin, wasquoted in the German newspaper Handelsblatt as saying that the prices that the gridcompanies charge industrial companies are bizarre and not covered by therenewable energy policy. In the same interview in Handelsblatt, Mr. Trittin called forthe appointment of an independent regulator to oversee the electricity companiesand ensure that they do not overcharge.

In our view, it is no coincidence that the Environment Ministry first called for anindependent regulator only one week after the FCO launched its inquiry into theprice of balancing power charged by RWE and E.ON. After all, the FCO inquiry gaveprima facie credibility to the Ministrys claim that rising prices for industrial userswere as much if not more a result of the utilities overcharging for balancing poweras of the surcharge on wind power itself.



Three weeks after Environment Minister Trittin gave this interview, the FederalGovernment surprised investors by saying that it would indeed appoint anindependent regulator beginning 1 July 2004. It would appear that, despite theEconomics Ministrys long-held view that the electricity industrys system of self-regulation worked effectively, the sensibilities of the Green Party members of theGovernment (notably Mr. Trittin himself) had to be respected on this point.

However, once the announcement was made, a Pandoras box was opened thatgoes way beyond the single issue of balancing power. As we said above, thedecision to introduce a regulator raises the much broader question of whether it willhave ex-ante price-setting powers of its own, or whether it will simply beresponsible for determining the methodology to be used, with industry participantsthemselves still actually negotiating the prices on a case-by-case basis.

In our view, what the Government ultimately decides will depend on the answer totwo questions:

Is the Government generally happy or unhappy with the way the electricity andgas markets have developed so far in the absence of a regulator?

Even if it is unhappy and wants to make radical changes to existing industrypractices (as might, for example, be the case in gas much more than inelectricity), is the Government constrained in what it can do?

8. To answer these questions, we have to be aware of a whole range of politicalfactors that will influence the decision-making process.

The art of the possibleFollowing Aristotle, Bismarck defined politics as the art of the possible (Die Kunstvom Moeglichen), and the same idea is encapsulated in the German wordRealpolitik.

Politics is determined by circumstances, and for this reason we think that the natureand scope of the regulatory framework to be introduced next year will to a largeextent reflect the interplay of certain key political realities in Germany today:

The desire of German industry for internationally competitive electricity and gasprices

The fragmented nature of the existing industry structure in electricity and gas,and the importance of municipal entities in the distribution part of the valuechain

The constraints on municipal finances

The Federal Governments stated policy objective of ensuring security of supply

Since we benchmark German electricity prices internationally in Section 5 of thisreport, we next review the last three of these factors, examining how we think theinterplay between them will determine the Governments decision-making processover the next few months, and the range of regulatory outcomes we expect thisprocess to lead to.



Section 3 The economics of the existing industry structureand the politics

Germanys electricity market is very concentrated in terms of generation andtransmission, but extremely fragmented in terms of distribution and supply.Generating companies like E.ON and RWE typically supply electricity to endcustomers on both a direct and indirect basis, as indicated in Figure 5.

This means that they either sell to end consumers directly themselves or through awholly- or majority-owned regional electric company; or, they sell to end usersindirectly through partly-owned regional distributors, or partly owned municipalutilities (Stadtwerke).

Looking purely at the network components of the value chain, there are in total over50 high-voltage grid companies in Germany, but most of the countrys transmissionnetwork is in the hands of four players (E.ON, RWE, EnBW, and Vattenfall Europe).In terms of the medium-to-low voltage part of the network, however, there areabout 900 players operating, most of them being municipal companies, typicallymajority-owned by local authorities.

Figure 5: Structure of the German electricity market

4 grid companiesGenerationTransmission - domestic and international

Distribution

Ca. 75 regional utilitiesOwn generation 20%Electricity purchases 80%

Transmission - regionalDistribution

Ca. 900 municipal utilitiesGeneration 10%Electricity purchases 90%

Distribution

Ca. 1/3

Ca. 1/3

Ca. 1/3

EN

D C

US

TOM

ER

Source: RWE

Germanys highly fragmented industry structure at the distribution level is verydifferent from that of most other European countries. As can be seen in Figure 6,with a total of 880, Germany has far more distribution companies than any other EUmember state, although Finland, Sweden, Denmark, and Austria all have a higherratio of distribution companies to total population.

Germanys gas-transportation industry displays a similar structure to that ofelectricity in that the high-pressure (transmission) part of the value chain is veryconcentrated, whereas the low-pressure part (distribution) is very fragmented. Asindicated in Figure 7, there are only 19 high-pressure networks in Germany, (fivesuper-regional transmission and 14 regional transmission companies), but 725companies distributing gas to end consumers at lower pressures.



Figure 6: The structure of the electricity-transportation industry across EU member statesNumber of transmission companies Number of distribution companies

Germany 4 880

Austria 3 155

Belgium 1 33

Denmark 2 77

Finland 1 100

France 1 172

Greece 1 1

Ireland 1 1

Italy 1 219

Luxembourg 0 15

Netherlands 1 18

Portugal 1 3

Spain 1 297

Sweden 1 248

UK 4 15Source: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April 2003

Comparing Germanys gas-transportation industry with those of other Europeancountries it can be seen that only Italy has a higher number of distributioncompanies, with 814 compared with Germanys 725. Interestingly, although Austria,Denmark, Finland, and Sweden have very fragmented distribution sectors inelectricity, they all have much more concentrated gas-distribution sectors.

Figure 7: The structure of the gas industry across EU member statesNumber of super-regional

transmission companiesNumber of regional

transmission companiesNumber of

distribution companies

Germany 5 14 725

Austria 3 5 20

Belgium 1 3 21

Denmark 1 0 4

France 2 1 21

Ireland 1 0 1

Italy 1 1 814

Luxembourg 1 0 4

Netherlands 2 0 25

Spain 1 3 26

Sweden 1 0 7

UK 1 0 1Source: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April 2003

Industry fragmentation and price variation: the network componentIn the European Commissions recently published study concerning theimplementation of the internal electricity and gas market European Commission,Second benchmarking report on the implementation of the internal electricity andgas market, Brussels, 7 April 2003 (hereafter abbreviated as EC, SBR 2003) end-user electricity and gas prices of various customer categories are indexed againstthose of large industrial users across the EU member states. The study reveals thatGermany has the highest differential of any EU member state between retailelectricity prices and those of large industrial consumers, but more modestdifferentials in both absolute and relative terms between retail gas prices andthose of large industrial consumers.



According to the Commissions report (EC, SBR 2003: page 18), in electricity theaverage price for German retail customers consuming 7.5MWh per year or less is120% higher than the price for large industrial users consuming 24GWh per year(Figure 8). This differential compares with a more modest differential between theseuser groups in the UK, Sweden and Finland of 90%, and a differential that is slightlysmaller still for the average of the other EU member states of 85%.

Interestingly, while the differential between prices paid by different customergroups increases progressively in the most liberalised markets (the UK, Sweden,and Finland), it is actually at its highest in both Germany and the remaining EUmember states between the large industrial users on the one hand, and the small-tomedium-sized consumers (50MWh per year) on the other.

Again, however, it is Germany that displays the largest differential in Germany it is145%, while in the UK and the Nordic countries it is only 68%, and in the remainingEU member states 98%.

Figure 8: Electricity price differentials across the EU indexed against users consuming 24GWh per yearPrice for customersconsuming 24GWh

per year or more

Price for customersconsuming 2GWhper year or more

Price for customersconsuming 50MWh

per year or more

Price for customers consuming 7.5MWh

per year or more

Germany 100 128 245 220

UK, Sweden, Finland 100 113 168 190

Other EU member states 100 128 198 185Source: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April 2003

In gas, Germany comes out of the comparison slightly better. According to thesame report (EC, SBR 2003: 25), the average price for German retail customersconsuming 2000 cubic metres per year or less is 75% higher than the price for largeindustrial users consuming 10mcm per year (Figure 9).

This compares with a differential of 65% in the UK, 95% in Spain, Belgium, Italy,and Luxembourg, and 115% in Denmark and France. This differential of 115% wasthe highest found in the survey across all customer categories. Unlike the case ofelectricity, the differential between prices paid by different customer groupsincreases progressively across all countries surveyed in the study, and Germanydoes not display the highest differential in any customer category.

Figure 9: Gas-price differentials across the EU indexed against users consuming 10m cum per yearPrice for customersconsuming 10mcm

per year or more

Price for customersconsuming 1mcmper year or more

Price for customersconsuming 10,000cm

per year or more

Price for customersconsuming 2,000cm

per year or more

Germany 100 120 155 175

UK 100 125 145 165

Spain, Belgium, Italy, Lux 100 112 172 195

Denmark, France 100 125 195 215Source: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April 2003

The wide range of price differentials found by the European Commission in its studyprompted it to conclude that market opening to date had not been as effective aswould intuitively have been expected. The Commission emphasised this point withregard to electricity in particular, noting that only the UK, Sweden and Finlanddisplayed the price-differential profile one would expect a priori: namely, that end-user prices should increase progressively as volumes consumed get smaller giventhe incremental wires and supply costs of smaller customers (EC, SBR 2003: 18):



Normally one would expect the ratios to be similar in each MemberState since prices should reflect the additional network and billingcosts of serving small customers. However, in many cases the ratiobetween prices at different levels and those for large users variesconsiderably. This is a clear indication that certain consumer groups,either households, small businesses or both, are payingdisproportionately high prices in some member states as a result ofincomplete or ineffective market opening. This contrasts with theposition in the UK and Nordic countries where the ratio betweenprices would appear to be more cost reflective.

In terms of the forthcoming introduction of a regulator in Germany, the crucialquestion raised by this EU study particularly with regard to Germanys electricitymarket is this: to what extent do the very wide price differentials betweendifferent customer categories reflect the network component of electricity tariffs?

This is a crucial question because if the reason the price differentials betweendifferent customer categories in Germany are so wide is because the networkcompanies are abusing their monopolistic positions (particularly at lower voltagelevels), then there would be a strong case for giving the new regulatory authority tobe established 1 July 2004 ex ante price-setting powers.

On the other hand, if there are other reasons that explain the wider end-user pricedifferentials in Germany than in any other country such as the structuralfragmentation of the industry then the pressure for a radical change to the existingsystem of self-regulation would probably not be so great.

So, what is the evidence with specific regard to network charges themselves? As isindicated in Figure 10, the range of absolute price levels for network charges inGermany clearly increases as the voltage level decreases. Other things being equal,this is what one would intuitively expect, since as the EC study quoted aboveemphasised, the network costs of serving smaller customers are higher than thoseof serving large industrial consumers.

However, the range of price levels at lower-voltage levels is not only higher inabsolute terms than those at high-voltage levels, it is also much wider. For example,while the difference between the highest and lowest high-voltage access charge is37% (1.59/1.16), the difference between the highest and lowest low-voltage accesscharge is 240% (6.98/2.05).

As we see it, this means that the central question in the debate over Germanregulation is whether this difference can be justified or not. In other words, do thesevariations in network-access charges simply result from the highly fragmentednature of the German distribution sector, and therefore fairly reflect structuraldifferences between different companies (as the industry association of electricitycompanies, the VDEW, maintains)? Or are these price differentials a reflection ofthe network companies ability to abuse a monopolistic position, particularly withregard to smaller customers?

To answer this question, we need to know how network prices are actually setunder the current nTPA regimes of the industry Verbndevereinbarungen, and howprices have developed since they came into force. We look first at the arrangementsin electricity, and then in gas.



Figure 10: The range of network access charges in Germany

2.05 - 6.98 ct/kWh

0

1

2

3

4

5

6

7

Low voltage Medium voltage High voltage

Eur

o c

ents

per

kW

h1.89 - 5.11ct/kWh

1.16 - 1.59ct/kWh

Source: VDN, VIK

Electricity: the current network-access arrangements (nTPA)As electricity is infrastructure-bound and the costs of building an alternative networkare prohibitive, competition is dependent on guaranteed fair access to the existingtransmission and distribution grid. To ensure this, the Utilities Association (VDEW),the Federation of German Industry (BDI) and the Association of Industrial EnergyProducers (VIK) established the first German Industry Agreement(Verbndevereinbarung) for electricity in July 1998.

This general agreement then spawned more specific guidelines for definingnetwork-access terms at high-voltage and medium-/low-voltage levels soonafterwards, namely the first Grid Code (July 1998) and the first Distribution Code(May 1999), respectively. Both the first Verbndevereinbarung and the networkcodes based upon it have subsequently been updated, and the current industrystandards are based on Verbndevereinbarung II+ (VVII+), which came into force on1 January 2002 and expires on 31 December 2003. Industry participants arecurrently negotiating an agreement to replace VVII+ beginning 1 January 2004.

Under VVII+ the price of network access is determined according to a cost-plusformula that allows for a return on equity of 6.5% (pre-tax real) to ensure that thevalue of the network assets is preserved (a concept known asNettosubstanzerhaltung). The industry agreement is meant to ensure that there isbroad comparability in access charges between structurally similar networks, withthe auditing of network access and charges being carried out by the FCO on an ex-post basis (as already explained above). The agreement ensures the separation ofnetwork and supply activities.

With regard to the pricing principles, customers (but not producers) pay a use-of-system charge that incorporates all voltage levels above that at which they taketheir power from the network (the so-called point-of-connection tariff). Since thecharge is defined at the point of connection, there is no distance element in theprice, but the tariff also includes the cost of losses, and ancillary services.



The components that are taken into account in the pricing formula are set out inFigure 11.

Figure 11: The components of the cost-plus formulaCosts and revenues/earnings items Data basis

Costs Profit and loss account

Material

Sub-contract charges

Personnel

Other costs

Taxes

Miscellaneous income

Financial result

Plus

Calculated depreciation Cost accounting

Taxes on the paper profit

Notional interest on equity capitalSource: RWE

The nTPA arrangements in Germany are only valid under EU law if they genuinelyensure non-discriminatory access to networks (except where there are validtechnical reasons to deny a third party access). This means that where a gridoperator is part of a vertically integrated company that also has subsidiaries active inelectricity supply, the prices charged to these intra-group companies must be thesame as those charged to third parties.

So much for the theory, but what does the experience of VVII+ and its predecessorstell us regarding the questions posed above, namely (1) why the differentialbetween different customer groups for total end-user electricity prices is so great inGermany, and (2) why the range in network-access prices increases so much as thevoltage level declines?

Does experience offer conclusive proof either way concerning whether theindustrys modus operandi under VVII+ is obstructive to competition and hence tolower prices? Can we establish whether network operators are taking advantage ofthe nTPA arrangements by discriminating in particular against smaller consumers?

Electricity prices and network charges under the VerbndevereinbarungenSince we consider the absolute level of German access charges relative to those ofother EU member states in detail in Section 5 of this report, we here restrict ourobservations to the trend in German electricity prices both total end-user prices,and network charges more specifically since market liberalisation began.

Again, our source for most of the information we analyse is the recently publishedstudy of the European Commission (EC, SBR 2003).

The trend in total end-user electricity prices

As can be seen in Figures 12-14, as far as the trend in total end-user electricityprices is concerned, there is a common pattern since the beginning of 1999,whereby German electricity prices for all customer groups have been high by EUstandards, but falling across all customer categories (large industrial, smallcommercial, and household) over the last four years.



Figure 12: Electricity prices for large industrial users in the EU since January 1999Low Medium High

Falling Sweden Luxembourg, UK,, Spain Germany

Stable Finland France, Netherlands, Greece

Rising Denmark Italy, Ireland, Belgium, PortugalSource: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April

Figure 13: Electricity prices for small commercial users in the EU since January 1999Low Medium High

Falling Sweden, UK Austria, Italy Germany, Belgium, Luxembourg

Stable Finland Portugal, Spain, France Ireland

Rising Denmark Netherlands, GreeceSource: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April

Figure 14: Electricity prices for household users in the EU since January 1999Low Medium High

Falling Greece, Austria Spain, UK Germany, Italy

Stable Sweden France Belgium, Portugal, Luxembourg

Rising Denmark, Finland Ireland, NetherlandsSource: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April

To the extent that the pattern is consistent across all customer categories, thiswould appear to be prima facie evidence that full market opening as it hasdeveloped in Germany under the aegis of VVII+ has not benefited one group morethan another unjustifiably. In this respect, it is instructive to quote the Commissionsinterpretation of experience across the different member states since liberalisationbegan in 1998, as it quotes the case of Germany approvingly (EC, SBR 2003: 7):

For electricity, it can be seen that prices in the UK, Germany andAustria have fallen across all consumer groups as a result of fullmarket opening, while prices in Sweden and Finland are also falling orreasonably stable at low levels. In other member states, there isusually a group which is either missing out on falling prices, orexperiencing price rises.

At the very least this means that one cannot conclude that the wider differentialbetween retail and large-industrial end-user prices in Germany than in any other EUmember state noted above is necessarily due to incomplete or ineffective marketopening (although this possibility is not disproved by the falling price trend across allcustomer groups in Germany since 1999 either). As we said above, the differentialbetween the total end-user electricity price for households and large-industrialconsumers may reflect other factors such as the fact that lower-voltage grid feesare higher, and their range wider, owing to structural factors.

The trend in network-access charges: the problem of balancing power

The most recently published data on trends in German network charges comesfrom the network operators association, the VDN. The VDN published its secondannual survey of trends in network charges in April 2003, and the data covered thesix-month period between 10 October 2002 and 18 March 2003. The trends acrossall three voltage levels are indicated in Figure 15.



Figure 15: Evolution of network charges, October 2002 March 2003High voltage Medium voltage Low voltage

Change over period excluding balancing charges (%) -8 -6 -4

Change over period including balancing charges (%) -0.4 -1.6 -1.2

Change in spread (%) -13 -34 -32Source: VDN

The good news in this data is that both the underlying fees themselves (that is, gridfees excluding balancing charges) and the range of fees paid in each voltagecategory have fallen across the board. High-voltage grid fees have fallen by 8% inunderlying terms, medium-voltage fees by 6%, and low-voltage fees by 4%. Thespread that is, the difference between the cheapest and the most expensiveaccess charges in each category has fallen by 13% at the high-voltage level, 34%at medium voltages, and 32% at low voltages.

As such, these trends in pricing and price differentials are consistent with theevidence in the EC survey quoted immediately above concerning the developmentof total end-user prices for each customer category. Thus, the fact that total end-user prices across all customer categories have been falling since liberalisationbegan in Germany is consistent with the fact that the network component of thetariff has also fallen across all end-user types.

However, the bad news in this data is that after adjusting for the increase inbalancing-power charges, the decrease in grid fees over this period is much lower.At the high-voltage level it is only 0.4%, at medium voltages 1.6%, and at lowvoltages 1.2% This indicates that the balancing-power component is of relativelygreater importance in the total-network charge for high-voltage customers than forlower-voltage consumers, and underlines why the German industrial usersassociation, the VIK, brought a formal complaint against E.ON and RWE to the FCOearlier this year.

Moreover, the problem with balancing charges in Germany is not just that they haveincreased so much in the last couple of years, but also that they display the biggestdifferential between top-up power-provision and spill-power-managementservices.

According to the European Commissions second benchmarking study on theimplementation of the internal market in electricity and gas, the price differentialbetween the price paid to generators for providing top-up power (known as thesystem buy price) and the price paid to generators for providing spill-energymanagement services (known as the system sell price) is on average more thanEuro 60MWh in Germany (EC, SBR 2003: 67).

The EC study notes that the system sell price in Germany rarely exceeds zero (EC,SBR 2003: 67), and that the size of this spread is negative from a competitivestandpoint as it creates an unfavourable situation with respect to new entrants,particularly pure retail suppliers without generation assets or companies with smallportfolios of customers which have less predictable demand than a large groupingof customers (EC, SBR 2003: 67-8).

In short, while grid charges appear to have fallen on an absolute basis in underlyingterms and the differentials within each voltage category appear to have narrowed,the impact of higher balancing charges has offset most of this benefit over theperiod most recently surveyed.



Conclusion on industry structure and current pricing mechanismsOn the basis of the information reviewed above, we would conclude the followingconcerning the effectiveness of the German electricity-industrys current method ofself-regulation with regard to liberalising markets in a manner consistent with theobjectives of the EU directives:

End-user prices in Germany have traditionally been high compared with otherEU member states, and display wider differentials between large industrialusers and residential consumers than those of other EU member states.However, prices have been falling across all customer categories since marketliberalisation began.

It is hard to say whether total end-user electricity prices in Germany are high inthe first place and display wider differentials between different user groups thanthose of other EU countries owing to overcharging by the network companiesmade possible by their ability to exploit their monopolistic position in theabsence of a regulator (especially at lower voltage levels), or for other reasons.These other reasons could include the structural characteristics of the industryat medium- and low-voltage levels (the fact that there are nearly 900 distributioncompanies and that this creates disparities concerning consumer density in theirservice areas, the volume carried over their networks, and so on).

However, in our view the fact that network charges have been falling across allvoltage levels in underlying terms, and that the differentials in each voltagecategory have been narrowing, make it difficult to conclude that VVII+ and itspredecessors have necessarily discriminated unfairly against different customercategories. Moreover, we show below (Section 5) that German high-voltageaccess charges do not look out of line with those of other EU member states,so the question is more urgent at the level of medium- and low-voltage charges(where, as shown in Section 5, prices do appear to be well above those of otherEU member states).

Ultimately, judging whether prices at lower-voltage levels are high as a result ofthe abuse of monopolistic positions or because of structural factors requiressignificant resources to make credible comparisons of Germany's 900 utilities.As we show below, this question of resources is likely to be a very importantfactor in the Governments decision-making process concerning which body isgiven responsibility for regulation, and how extensive the powers that body isgiven are.

In any case, we think that the importance of the municipalities in the distributionsector of the value chain means that there is a political dimension to theGovernments decision-making process over regulation that also has to befactored into the equation (we discuss this below).

E.ON and RWE may be exposed on the question of balancing power, and theprofits their generation businesses are making in this area at the moment fromproviding top-up and spill energy-management services at allegedlyunjustifiably high prices.

Gas: the current network-access arrangements (nTPA)Unlike its electricity counterparts, the Verbndevereinbarungen in gas have from theoutset distinguished between the pricing methodologies to be used in transmissionon the one hand, and in distribution on the other. The industry currently operatesunder the terms of reference of VVII, which replaced the original agreement, VVI, ofJuly 2000. On the network providers side, the gas-industry agreements wereentered into by the industry groups representing their interests (the German Gasand Water Association, or BGW, and the municipal utilities association, the VKU).



On the network users side, it was the Federation of German Industry (BDI) and theAssociation of Industrial Energy Producers (VIK) that helped define the agreementsparameters.

VVII came into force in May 2002 and expires on 30 September. However,negotiations for VVIII, which was the agreement due to come into force from1 October, broke down in April, and it looks increasingly unlikely that the differentparties will now be able to broker VVIII in time for it to enter into force by that date.This makes it quite likely that the Government will have to replace the industryssystem of self-regulation with a temporary regulatory framework for the six monthsbetween the ending of the validity of the general assumption that the currentindustry agreement represents good practice, and the start date for the newregulator (31 December 2003 30 June 2004).

VVII is legally obliged to ensure non-discriminatory access, and the main features ofthe agreement as they relate to access and charges are as follows:

Transmission: Unlike the charges for electricity transmission, access chargesto the high-pressure gas network are distance related, and operate under asystem of so-called point-to-point pricing. Network users pay a fee based onthe distance between the points on the grid over which they carry their gas,multiplied by the volume transported. Significantly, there is no cost-plusformula for setting prices, but since suppliers are restricted in terms of the high-pressure pipelines they can use to transport their gas, it is not exactly a market-price-setting system either. The absence of realistic alternative transportationroutes and of a clear even if voluntarily agreed upon rather than regulatedcost-plus pricing formula (such as exists in electricity) has led to persistentaccusations of de facto monopolistic rent-seeking on the part of the networkcompanies.

Distribution: As with electricity, the price of network access is determinedaccording to a cost-plus formula but the return on equity allowed is higher at7.8% (pre-tax real). Again, the industry agreement is meant to ensure that thereis broad comparability in access charges between structurally similar networks,with the auditing carried out ex-post by the FCO. Access charges are calculatedon a stamp-fee basis, and are thus unaffected by the distance over which gasis carried by the supplier. The agreement ensures the separation of network andsupply activities.

In our view, it is by no means intuitively obvious that access to gas-transmissionnetworks should use a different pricing methodology from that used by theelectricity industry, and this apparent anomaly has been the biggest obstacle to therelevant parties ability to agree VVIII. The user organisations had been pushing forVVIII to abandon point-to-point pricing in favour of a point-of-connection basedaccess-charge formula, but the high-pressure network companies proved unwillingto accede to this demand.

As we explain further below (see The political dimension), this may ultimately resultin the methodology used to regulate gas-transmission networks being different fromthat used for the high voltage power networks.



Figure 16: Gas prices for large industrial users in the EU since July 2000Low Medium High

Falling France, Sweden Spain Luxembourg

Stable Belgium, Denmark, Italy Germany

Rising Austria, UKSource: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April

Figure 17: Gas prices for small commercial users in the EU since July 2000Low Medium High

Falling Sweden, Spain Denmark

Stable Belgium, Luxembourg, Ireland Italy

Rising UK, Netherlands France, Germany AustriaSource: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April

Figure 18: Gas prices for household users in the EU since July 2000Low Medium High

Falling Denmark

Stable UK, Luxembourg Ireland, Belgium, Italy Spain

Rising Netherlands Sweden, Austria Germany, FranceSource: European Commission, Second benchmarking report on the implementation of the internal electricity and gas market, Brussels, 7 April

The trend in gas prices under the VerbndevereinbarungenAs we saw above, the differential between large industrial and retail consumers inGermany in terms of the total end-user gas price is smaller than in the case ofelectricity, but this does not necessarily mean that the gas Verbndevereinbarungenhave been more effective in ensuring competitive network pricing.

For one thing, this could simply reflect the fact that the electricity distributionnetwork is slightly more fragmented than that of gas (880 companies comparedwith 725 in gas). Moreover, if we compare the trend in total end-user prices sincemarket liberalisation began in gas in EU member states in July 2000, it is clear thatgas prices in Germany have been much more resistant to falls than those inelectricity.

Figures 1618 show that no customer group in Germany of the three categoriessurveyed (large industrial, small commercial and household) has enjoyed falling end-user prices since the process of liberalisation began. It could be argued that end-user price reductions would have been more difficult in gas than electricity due tothe rise in natural gas input prices since 2000 (which are linked to oil prices).However, other countries, also on oil-linked gas contracts, have achieved falling end-user prices over the same time period. Moreover, not only are prices high comparedwith the EU average in two of the categories (large industrial, and household), theyhave actually risen for small commercial users (albeit from levels consistent with theEU average), and for households (from an already high base). While this data is notconclusive concerning the network component of the total end-user price, it is primafacie evidence that the Verbndevereinbarungen in gas have not delivered theeffective market opening that the EU directives require. Not surprisingly, this wasthe verdict of the recent EC study on the basis of this evidence (EC, SBR 2003:7).

We conclude from this that the progress made by the gas industry under self-regulation has been less effective than that of the electricity industry in terms ofdelivering the degree of market opening required by EU energy policy. This couldhave consequences for the regulatory methodology the German Governmentultimately adopts for gas as compared with electricity.



The political dimensionThere is no doubt that the introduction of a regulatory framework in Germany isgoing to change the energy industrys existing pricing mechanisms for networkcharges, but this change will be a function not only of the economics of currentpricing mechanisms (as reviewed above and as analysed comparatively in Section 5below), but also the politics.

In particular, as we mentioned above, the Government has to balance a number offactors in making its decision on regulation, the most important of which we see asthe following:

The desire of German industry for competitive electricity and gas prices

The existing industry structures and practices, and the importance of municipalentities in the distribution part of the value chain

The constraints on municipal finances

The Federal Governments stated policy objective of ensuring security of supply

So, how important is each of these factors on Government thinking?

In our view, the most instructive way to answer this question is to review what theGerman Chancellor, Gerhard Schroeder, himself said concerning the factors that willinfluence the Governments decision on regulation at the speech he gave to theVDEW Conference in Berlin last month. Since no English translation of the speechwas made by the VDEW, we quote from the original German, accompanying eachextract with our own English translation.

The importance of transparent and competitive energy pricesChancellor Schroeder emphasised in his speech that with regard to theestablishment of a regulator the framework will have to be rules-based, transparent,and non-discriminatory, in order to ensure competition and sustainably low prices forindustry and the economy more generally:

Von der Politik wird ein ordnungspolitisches Geruest verlangt. MehrKonkurrenz und niedrige Preise werden wir nur dann dauerhafterhalten koennen, wenn der Staat in enger Kooperation mit derWirtschaft fuer faire Marktbedingungen sorgt. Ueber diese Frage wirdim August ein Monitoring-Bericht des Bundesministeriums fuerWirtschaft und Arbeit vorgelegt, der exakt ueber den Stand derEnergiemarktliberaliserung in Deutschland informiert. Danach wird dasBundeswirtschaftsministerium im Herbst dieses Jahres Vorschlaegevorlegen koennen, wie die neue Wettbewerbsbehoerde fuer dieStrom- und Gasmaerkte organisiert werden kann und welchekonkreten Verfahren der Regulierung sie anwenden wird.

Policy here requires a rules-based framework. Increased competitionand low prices can only be sustained if the State cooperates closelywith industry and the economy to ensure fair market conditions. Thisquestion will be addressed in a monitoring report to be presented tothe Ministry of Economy and Employment in August, which will give aprecise assessment of the (current) state of liberalisation in theGerman energy market. The Federal Economics Ministry will then beable to propose how the new authority responsible for competition inthe electricity-and gas markets can be organised, and exactly whatregulation methodology it will use. (Chancellor Schroeder, VDEWconference, Berlin, 3 June 2003)



At the same time, Herr Schroeder emphasised that the right balance needs to bestruck between competitiveness on the one hand, and the ability of the gridcompanies to invest on the other:

Was ist uns dabei wichtig? Ungehinderter Marktzugang fuer Anbieter vonStrom und Gas und faire Durchleitungsentgelte. Fair heisst: nicht nurkostenguenstig fuer den, der durchleiten will; Fair heisst eben auch, dass essich fuer diejenigen, die investieren, die auch in Zukunft investierenkoennen und wollen, auch betriebswirtschaftlich rechnet. Fairness indiesem Bereich heisst also zweierlei: Die Preise muessen stimmen, und sieduerfen den Marktzugang nicht verhindern; Aber die Netzinvestitionenmuessen sich auch in Zukunft lohnen.

What is important in all of this? Unimpeded market access for electricityand gas suppliers and fair remuneration of the network. The concept offairness means not only competitive prices for those wanting access to thenetwork, but also sufficiently attractive prices for those who invest (in thenetwork), and who can and want to continue investing in it in the future.Fairness on this point thus means two things: prices must be right, andmust not hinder market access; but investment in the grid must also remainworthwhile, must also be rewarded, in the future.

(Chancellor Schroeder, VDEW conference, Berlin, 3 June 2003)

Indeed, the Chancellor said in his speech that while a key concern behind theintroduction of a regulatory authority was ensuring the competitiveness of Germanindustry, this included ensuring the competitiveness of the energy industry itself,not least because German utilities have to be able to compete in Europe and evenglobally. In this respect, Herr Schroeder said that the Government would want tolearn from the experience of regulating other German industries -- notably thetelecommunications industry which had not always been positive:

Es gibt auch bei der Regulierung nicht nur positive Erfahrungen inanderen Bereichen, zum Beispiel bei der Telekommunikation; Ichmoechte gerne, dass die Klage ueber die Neigung zurUeberregulierung und die schlechten Moeglichkeiten der betroffenenUnternehmen, sich auf der Weltmarkten oder jedenfalls auf deneuropaeischen Markten zu behaupten, sich nicht wiederholt. In einemvernuenftigen Dialog zwischen Bundesregierung und der Wirtschaftkoennen wir verhindern, dass sich diese Erfahrungen, soweit sienegativ waren, wiederholen.

Experience of regulation in other spheres, for exampletelecommunications, has not been exclusively positive. I am keen toavoid a repetition of accusations concerning a tendency towards over-regulation and the difficulties this creates for the firms affected toassert themselves on world markets, or at least on the Europeanmarket. Through sensible dialogue between the Government andindustry, we can avoid a repetition of the negative aspects of pastexperience. (Chancellor Schroeder, VDEW conference, Berlin, 3 June2003)

In our view, these extracts are a fair reflection of the content of Herr Schroedersspeech concerning the need of the new regulatory framework for energy to ensurecompetitive electricity and gas prices for German industry.



We think that he was careful to balance this consideration against the need toprovide incentives for future investment in energy networks, and to ensure thecompetitiveness of German utilities in a European context is not damaged by over-regulation.

Does this mean that the Government is generally happy with the way the energymarket has developed in the absence of a regulator? In other words, to the extentthat Chancellor Schroeder is concerned about ensuring that the future regulatoryframework continues to provide incentives for investment in grid networks (aconcern that reflects the fundamental energy-policy aim of any Government ofensuring security and reliability of supply), does this mean that he thinks theindustrys system of self-regulation under nTPA has been effective in deliveringreliability?

And to the extent that the Chancellor does not want the internationalcompetitiveness of German utilities to be damaged by over-regulation, does thismean that the Government thinks that the energy industrys current structures andpricing mechanisms have produced efficient electricity and gas companies, andhence that it might be worth retaining a large part of the Verbndevereinbarungen?

The Governments attitude towards existing industry structures and practicesChancellor Schroeder stated in his speech that Germany could, on the whole, takepride in the way in which the countrys 900 utility companies delivered energyefficiently and reliably:

Es gibt nahezu 900 deutsche Energieversorger: kleine odermittelgrosse Stadtwerke oder aber die, wenn ich das so sagen darf,global player in der Energiewirtschaft. Ich sage ohne irgendeineEinschraenkung: man kann stolz darauf sein, dass diese Unternehmeninsgesamt natuerlich gibt es da Unterschiede ein Musterbeispielfuer die Effizienz und die Zuverlaessigkeit der Energieversorgung inDeutschland sind.

There are nearly 900 German energy companies: from small andmedium-sized municipal utilities to those that, if I can put it this way,are global energy players. I say without any reservation that we can beproud of the fact that overall clearly, there are differences betweenthem -- these companies exemplify Germanys efficiency and reliabilityin energy supply. (Chancellor Schroeder, VDEW conference, Berlin, 3June 2003)

As far as the claim for reliability of supply is concerned, Chancellor Schroeder coulddefend this by pointing to the findings of the recent EC report on the internalmarkets implementation across the EU member states. For example, de

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German Utility Regulation

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