On 1 November a new European Commission takes office for the next five years. Energy, as with most other portfolios, has a new Commissioner with Laslo Kovacs replacing Loyola de Palacio. Unfortunately for Kovacs he will inherit a portfolio peppered with teething troubles at a time when Europe would be well on its way to achieving an internal energy market if the directives put forward by de Palacio had been realised. But de Palacio’s flagship directive for full wholesale competition in gas and electricity markets from 1 July has, concedes the Commission, yet to be fully implemented by 23 of the 25 member states. A planned benchmarking report scheduled for the end of 2005 is unlikely make pleasant reading and the prognosis for the second part of the directive, full competition (to domestic level) by July 2007 is now little more than wishful thinking.

In a speech to the European Parliament on 30 September, Kovacs told MEPs that the Commission’s energy department is split over plans for more market opening laws to address defects in the EU’s internal energy market. Apparently the preferred option is for a third directive, even though the second directive mandating full wholesale competition has been wholly unsuccessful. The alternative option, to make sure the second directive is fully enforced, would seem to be the common sense approach. But while common sense appears to be in short supply at the Commission, which is fast becoming a bureaucratic behemoth, irony is clearly not. Kovacs said in his speech that the hardest part of his job would be to convince those in the market with a dominant position to give it up. But it is the Commission that has rubber stamped these dominant companies.

It is now five years, almost six, since the 1999 directive to commence the deregulation of Europe’s electricity market was introduced, and four years since the first gas directive. On paper the market is more competitive but in reality competition has been painfully slow to develop. If linear progress toward competition were to be followed from the 1999 directive we could be well into the next decade, and the next European Commission, before the ideals of a fully competitive market are realised. But equally full competition may continue to be just that, an ideal, and the current level of competition may be as good as it gets.

… and the EU ETS

Last month the EU Emissions Trading Scheme (ETS) reached the symbolic trading volume of one million tonnes in a single calendar month. Some commentators were quick to actively talk up the embryonic EU ETS, arguing that market liquidity will now rapidly improve and an actively traded emissions market will evolve as envisaged. Certainly the timing of the new volume record proved convenient, as barely a few days later Russia announced that it will finally ratify the Kyoto Protocol, making it internationally binding and representing just under 65% of global emissions.

But a new volume record, however impressive, and Russia’s ratification should not detract from the problems seemingly inherent in the scheme. Only eight allocation plans have been approved, most conditionally, and at the time of writing this column the Commission had announced a delay to the publication of the second series of assessments, due at the end of September. And Greece is now unlikely to have its final allocation plan submitted before Christmas.

The growth in trading volumes can largely be attributed to the entrance of non-commercial participants into the ETS, particularly banks, which have tended to focus on calendar spreads and in particular the 2005-2007 spread which covers the first voluntary phase of the scheme. Typically this spread trading is either based on cost of capital, ie whether investing in the ETS gives a better rate of return than leaving the money in the bank, or is based on perceived correlations between emission and power prices. Both approaches represent structured transactions and are clearly speculative in nature.

What this development in trading volumes shows is that the market is conforming to a ‘typical’ commodity market development whereby first the market trades structured products then standardised products and finally trades options on standardised products. At the moment the ETS is very much in the ‘structured’ trading phase of development and it is only when liquidity develops sufficiently that more standardised trading will evolve. But any development of standardised trading will arguably be dependent on the efficient introduction of the ETS in January 2005 combined with sufficient scarcity of allowances to incentivise the commercial participants (utilities and industrials) to actually trade. Unfortunately neither of these criteria appears likely to be met.

At the end of September the European commissioner-designate for the environment, Stavros Dimas, infuriated the European Greens by simply stating the obvious; that some member states will not be ready for the official start of the ETS in January. While the Greens bemoaned this statement, saying it confirmed their fears that the new Commission intends to downgrade environmental protection, it is not the incoming Commission that is at fault but arguably the one just coming to the end of its five year term. By accepting weak allocation plans the outgoing Commission can be accused of downgrading environmental protection and, through not ensuring a degree of allowance scarcity, limiting the potential of the ETS in the first phase.

From a trading perspective this development, or lack of it, would appear to favour the non-commercial activity in the market and a continuation of mainly structured trades. But a healthy commodity market requires the active participation of both commercial and non-commercial players. While the increase in trade volume above a million tonnes in a single month is undoubtedly a positive development its significance may be over-rated. The real challenge for the ETS will be all 25 member states having emission trading legislation in place, sufficient allowance scarcity to encourage trading and a liquid standardised emissions market. Such a development seems unlikely to take place by the scheduled January start of the ETS, and may well be some time off.