Henrik K.

Thorrud

An analysis of the issues posed for EU Competition Law by long-term energy supply contracts in the liberalised European market

1. Introduction The energy sector has traditionally been characterised by a few vertically integrated incumbents bringing electricity and gas to the European consumer.1 The liberalisation of energy markets in the EU is still ongoing, with a third legislative package under way. 2 This implies the opening up of energy markets to competition and a new role for the state. 3 In this new setting, competition authorities are confronted with the difficult task of fighting anticompetitive practices, while at the same time ensuring legal certainty to market players and promoting the security of supply.4 The tackling of long-term supply contracts (LTC) represents one of these difficulties.5 The energy community stresses that LTCs are necessary to ensure an optimal allocation of risks among contracting parties and hence, a socially beneficial level of investment, whereas the European Commission (hereafter the Commission) is very concerned that these contracts may lead to the elimination of competition under Article 101 TFEU (Treaty of Lisbon).6 The object of this paper is to provide a basic outline of the antitrust dilemma being confronted by the Commission and what considerations need to be taken into account. After an explanation of what LTCs are and why they are used, an overview of LTCs in the light of competition policy will be presented, followed by a legal assessment of such contracts. The last chapter will analyse the relationship between LTCs and security of supply. 2. What are long-term energy supply contracts and why are they used? Long-term energy supply contracts are bilateral contracts between a seller of energy and a buyer, as opposed to trade of energy on the wholesale market.7 Such contracts are concluded all along the energy supply chain.8 LTCs are often beneficial for both parties, at least as a complement to spot-market trading.9 The main rationale for LTCs is allocating price and quantity risks for a longer period of time, so duration is crucial. 10 In addition to duration,
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Coop, Long-term energy sale contracts and market liberalisation in new EU Member States Are they compatible? International Energy Law & Taxation Review (2006) 64 (Hereafter Coop). 2 OJ L 211 [14 August 2009] <http://ec.europa.eu/energy/gas_electricity/third_legislative_package_en.htm>. 3 Hauteclocque, EC Antitrust Enforcement in the Aftermath of the Energy Sector Inquiry: A Focus on Long Term Supply Contracts in Electricity and Gas in Delvaux, Hunt, Talus, EU Energy Law and Policy Issues (ELRF Collection First Edition, Euroconfidentiel, Brussels (2008) 91 (Hereafter Hauteclocque, EC Antitrust Enforcement). 4 Hauteclocque, Legal Uncertainty and Competition Policy in Deregulated Network Industries: The Case of Long-term Vertical Contracts in the EU Electricity Markets in Larsen Working Paper, June 2008 1. (Hereafter Hauteclocque, Legal Uncertainty). 5 ibid. 6 DG Competition Report on Energy Sector Inquiry, SEC (2006) 1724, 10 January 2007, 232 244 and 283294 (Hereafter Sector Inquiry). 7 Hauteclocque, Legal Uncertainty 2. 8 ibid. 9 ibid 3. 10 ibid.

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LTCs also define other aspects of the transaction, such as use restrictions, renegotiation conditions, quantity and price, with some flexibility.11 LTCs typically contain take-or-pay clauses, which require purchasers to pay for a pre-specified minimum quantity of gas or electricity, whether or not that amount is actually taken, and require the producer to deliver this quantity.12 This is a way of allocating the risk of quantity to the buyer.13 Traditionally, LTCs have been seen as a way for the supplier to secure long-term revenues, which in turn is necessary for the financing of exploration, production and transportation of the energy to the buyer.14 Another important incentive for the seller is to lock in customers, hence the longer the duration the better. Also, LTCs allow incumbents to benefit from economies of scale15 and reduce transaction costs for both parties, as they do not need to frequently negotiate new contracts. From the buyers perspective (if the buyer is a producer), LTCs secure the supply of energy in the medium and long term and thus provide predictability, which facilitates project financing for generators.16 End-consumers (industrial and commercial users)17 might be motivated by the opportunity to negotiate stable, favourable terms and avoid the volatile prices on the wholesale market.18 3. Long-term contracts and competition policy Traditionally, LTCs have been considered essential for security of supply and thus not only tolerable, but also desirable.19 In the setting of free and efficient competition, LTCs are now considered in another light.20 In the Commissions opinion, LTCs conflict with the rationale of liberalisation (to introduce greater competition in energy markets throughout the EU).21 Increased competition is desirable, as it incentivises firms to provide a better quality of service for their customers, to keep costs down and to innovate.22 An optimal level of competition is also deemed to better allocate scant resources and deploy them more efficiently.23 The antitrust policy is essentially aimed at maximising long-term social welfare, especially consumer welfare.24 If need be, the economic freedom of action must be constrained to reach a greater social value in the long term.25

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ibid. Neuhoff and von Hirschhausen, Long-Term vs Short-Term Contracts: A European Perspective on Natural Gas Globalization of Natural Gas Markets Working Papers 12 (2005), 2. 13 Coop 65. 14 ibid 64. 15 Cameron, Competition in Energy Markets, Law and Regulation in the European Union (2nd edition OUP, Oxford 2007) 325 (Hereafter Cameron). 16 Talus, Long-term gas agreements and security of supply between law and politics, European Law Review 32 (2007), 536 (Hereafter Talus). 17 Cameron 325. 18 Talus 536. 19 ibid. 20 ibid. 21 Evans and OReilly, Competition Authority Policy and Enforcement in the Irish Electricity Sector: Implications of Recent Market Developments, SMi Energy Conference 27 November 2003, 2 (Hereafter E&O). 22 ibid. 23 Cameron 5. 24 Hauteclocque, Long-term energy supply contracts in European competition policy: Fuzzy not crazy (2009) 37 Energy Policy 5399, 5400 (Hereafter Hauteclocque, Fuzzy not crazy). 25 ibid.

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LTC effects on social welfare are ambiguous both in the short and long term.26 The positive effects can be summarised as the prevention of double marginalisation, facilitation of entry and investment and thus, contribution to long-term generation adequacy and fuel mix diversity.27 The main anti-competitive effect is the risk of foreclosure of more efficient players.28 LTCs also influence the spot-markets.29 On the one hand, the use of long-term contracts may dry out these markets and thus increase volatility, and incentivise market players towards vertical (re)integration or to keep using LTCs (feed back effect). 30 On the other hand, it may also prevent abuse of dominance on spot-markets, as price increases would only be profitable on the un-contracted part of their supplies (as long as LTCs are not indexed on spot prices).31 Economic theory has not delivered any clear solution to the antitrust dilemma with LTC; it merely shows the different elements to be taken into account to conduct the balancing exercise.32 Many factors influence the effect of LTC on welfare, such as the different risks involved, the evolution of supply and demand, the storability of the product, market structure and primarily who is signing the contract [on what terms] .33 In order to comply with the goal of increased welfare, it is deemed necessary to apply an antitrust policy in an intelligent way.34 If a new entry clearly depends on the signing of a LTC, it could be justified because efficiency gains offset anti-competitive effects.35 On the contrary, that might not be the case for a super-dominant incumbent already having a wide customer base, even for investments in very high fixed-costs technologies such as nuclear.36 4. The legal assessment of long-term contracts Art 101 TFEU, which regulates anti-competitive agreements, and Art 102, which regulates abuse of a dominant position, as well as relevant guidelines and notices, provide the legal basis for assessing LTC.37 In the Belgian Distrigas Case38, the European Commission found that Distrigas, the largest gas supplier and importer in Belgium, prevented new suppliers from entering the Belgian gas market and thus opened a TFEU Art 102 proceeding.39 Due to having long-term contracts with many industrial consumers, a significant part of gas demand in the country was met and closed to competition for long periods.40 This case deals with the

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Hauteclocque, Legal Uncertainty 3. ibid. 28 ibid. 29 ibid. 30 ibid. 31 ibid. 32 Hauteclocque, Fuzzy not crazy 5402. 33 ibid. 34 ibid. 35 ibid. 36 ibid. 37 Hauteclocque, EC Antitrust Enforcement 96. 38 Case COMP/B-1/37966 Distrigas of 11.10.2007. 39 European Commission, MEMO/06/197, 16.05.2006. 40 Case COMP/B-1/37966 Distrigas 6.

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problem of foreclosure of potential competitors, which is also raised and discussed in the Energy Sector Inquiry.41 In October 2007 the Commission ended the procedure by way of welcoming Distrigas commitments to remedy competition problems in the Belgian gas markets. 42 Distrigas promised to reduce the amount of gas sold under LTC, which enables other gas suppliers to compete for the demand freed up.43 Of the gas sold by Distrigas, 70% must be contracted for a maximum of one year.44 The maximum duration of gas supply contracts with resellers is two years, with large gas consumers (industrial consumers and electricity generators) five years.45 Supplies to new gas-fired power plants are excluded from the commitments, due to policy reasons of increasing supply capacity.46 LTCs are not per se illegal.47 When assessing their compatibility with EU competition law, these five elements will be considered: (i) the market position of the supplier, (ii) the share of the customers demand tied under the contract, (iii) the duration of the contracts (iv) the overall share of the market covered by contracts containing such ties, and (v) efficiencies.48 In what follows, the above-mentioned criteria will be examined: A) The Market Position of the Supplier Because LTCs can be used to stabilise market shares over long periods, it is crucial to consider the market position of the supplier. If the supplier has a dominant position in the relevant market, as with Distrigas, the portfolio of its contracts will be assessed. 49 In case no single firm is dominant, the cumulative effect of the bundle of contracts concluded by a group of suppliers will be considered.50 The higher the market share of the dominant supplier, the sooner the cumulative market coverage of its [LTC] will be deemed to create foreclosure.51 B) The Share of the Customers Demand Tied Under the Contract It is an important source of foreclosure effect.52 Customers who have all or most of their needs met by a particular supplier are inaccessible for competitors or potential entrants.53 Transaction costs can make negotiating for small quantities uneconomical. 54 According to the German Federal Cartel Office (FCO) (Bundeskartellamt), a second supplier must have the opportunity to obtain at least 20% of a customers demand to have the incentive to close a
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Sector Inquiry 232244 and 283294. Bellantuono, Long-term contracts in US and EU: Where are we going? , 10,2 Competition and Regulation in Network Industries, 2 (Hereafter Bellantuono) cf. Commission Press Release MEMO/07/407, 11.10.2007. 43 Case COMP/B-1/37966 Distrigas 8. 44 ibid. 45 ibid. 46 ibid. 47 Hautleclocque, EC Antitrust Enforcement 96 cf Bellantuono 12. 48 European Commission, MEMO/07/407, 11.10.2007. 49 ibid. 50 ibid. 51 Hauteclocque, Legal Uncertainty 6 cf. Commission Notice on Guidelines on Vertical Restraints [2000] OJ C291/1 (GVR) para.149 52 Hauteclocque, Legal Uncertainty 7 53 ibid 54 ibid

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supply contract.55 The competition authorities also operate with a black list of clauses, which infringes competition rules (e.g. market partitioning clauses, use restrictions and contractual provisions having similar effect).56 C) The Duration of Contracts The share of a customers demand tied under the contract and its duration must be analysed in conjunction.57 Foreclosure will not occur even if 100% of the demand is met by a particular supplier as long as a customer can return to the market every year. 58 Customers tied in the long-term cannot switch for a better offer.59 The Commission considers that efficiencies generally do not offset foreclosure effects beyond five years.60 If the counterparty is an established reseller, the maximum allowed duration is two years.61 In the E.ON Ruhrgas case,62 the German FCO limited the duration for LTC with established resellers supplying more than 50% of overall demand to four years, and two years above 80%.63 D) The Overall Share of the Market Covered by Contracts Containing such Ties Under this criterion, the cumulative effect of the parallel network of LTCs on market foreclosure will be assessed.64 A substantial part of market demand (i.e. over 30% of global demand) must be tied for the long term before the Commission raises concerns.65 E) Efficiencies In case the Commission considers that a LTC, or a portfolio of LTC, is likely to create significant anti-competitive effects, it will assess whether it generates efficiencies that offset the negative effects, as long as hardcore restraints are not included.66 This balancing exercise is carried out in accordance with the four criteria set out in TFEU Art 101 litra 3.67 In order for LTC with substantial anti-competitive effects to be tolerated by competition authorities, they should (i) substantially improve economic efficiency, (ii) give a fair share of benefits to final consumers, (iii) be indispensable or at least proportional to the achievement of the efficiency gains and (iv) not afford contracting parties the possibility of eliminating competition in respect of a substantial part of the products in question.68
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Bundeskartellamt, 8th Decision Division, B-113/03, Bonn [28 January 2005] <http://www.bundeskartellamt.de/wDeutsch/download/pdf/Diskussionsbeitraege/050125_DiskussionspapierGas vertraege.pdf> 11, 1314 56 Hauteclocque, Fuzzy not crazy 5403 57 Hauteclocque, Legal Uncertainty 7. 58 ibid. 59 ibid. 60 ibid cf Case COMP/B-1/37966 Distrigas 8. 61 ibid cf Case COMP/B-1/37966 Distrigas 8. 62 Bundeskartellamt, 8th Decision Division, B-113/03, Bonn [13 January 2006]. <http://www.bundeskartellamt.de/wDeutsch/entscheidungen/Kartellrecht/EntschKartell.shtml> 63 ibid 3. 64 Hauteclocque, Legal Uncertainty 8. 65 ibid. 66 Hauteclocque, Fuzzy not crazy 5405. 67 ibid. 68 ibid.

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Pursuant to the first criterion, the LTC must create significant efficiency gains to be accepted.69 The European Commission has mainly recognised investment and entry as efficiency gains.70 The need to secure financing of new infrastructure is the most commonly used argument to defend LTCs and was accepted by the Commission in the Distrigas Case.71 However, the Commission is generally critical of this argument. 72 The Sector Inquiry points out that the additional capacity created this way usually ends up in the hands of those companies already controlling the pre-existing capacity.73 The Commission is reluctant to conclude that efficiencies will offset the anticompetitive effects of LTC in the long run.74 However, the Commission will not necessarily cancel the agreement, but may impose remedies to mitigate these effects as it did in the Distrigas case.75 5. Security of supply and competition Competition policy must take the sector-specific factors into account. One of the main goals in the energy sector is to secure the supply of energy, as blackouts are fatal.76 (Other crucial objects are continuity of supply and environmental sustainability).77 An essential question is how to maintain security of supply and yet foster optimal competition. Are these two goals compatible? This is controversial.78 It is indeed doubtful whether investments enhancing security of supply will be carried out without certainty to market players.79 Since natural gas production depends both on raw gas often found faraway from the EU and long-term investment, there is a stronger emphasis on the long-term than in electricity.80 The Commission wants gasimporting companies to buy in liquid spot-markets.81 However, this will not prevent powerful exporting companies which will become more important as domestic production decreases82 to ask for long-term commitments.83 Importing companies will have no choice but to buy without being able to secure customers in advance, which would make investments difficult.84 The development of a liquid spot-market presupposes that exporting countries are willing to sell on a volatile exchange at lower prices rather than concluding LTC. 85 It is not clear why they would do that. To forbid LTC before the alternative of liquid and transparent
69 70

ibid. Hauteclocque, Legal Uncertainty 8. 71 Bellantuono 12. 72 ibid. 73 ibid cf Sector Inquiry 85. 74 Hauteclocque, Legal Uncertainty 8. 75 Hauteclocque, Fuzzy not crazy 54055406. 76 CEPS Task Force Report No. 52, Dec 2004, Rethinking the EU Regulatory Strategy for the Internal Energy Market 1, 23 (Hereafter CEPS). 77 E&O 3. 78 Coop 64. 79 Bellantuono 13. 80 CEPS 17. 81 Bellantuono 14. 82 Ungerer, Recent developments in the European Gas Sector A Competition Perspective, 14th European Gas Conference, Oslo, 1416 May 2007, 5. 83 Bellantuno 14. 84 ibid. 85 ibid.

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markets for supply and transport is available, risks being contra-productive.86In a scenario of ownership unbundling of transmission networks, network operators could also be unwilling to invest without long-term commitments by suppliers.87 On the other hand, the Sector Inquiry argues that promoting competition is generally the best way to encourage investments.88 It documents several cases showing that investments have been delayed to deter entry by competitors.89 A possible remedy is to weaken the market power of incumbents.90 It was also, more controversially, suggested that investments in the energy sector are market-specific and not relationship-specific. According to this theory, investing companies can profit by investments without LTC with a large number of customers.91 A possible solution to this problem could be to build energy markets in which contracting parties are free to hedge risks with long-term agreements, while at the same time are prevented from exploiting such agreements for anti-competitive purposes.92 The economic freedom of action should not be confined more than necessary to prevent abuses of market power.93 6. Conclusion This article has shown that the effects of LTC on competition, investment and welfare are ambiguous. The two main factors when assessing LTC from a competition law point of view is the political question of security of supply versus prevention of foreclosure effects. These two considerations do not necessarily go hand in hand, and it might be that one excludes the other.94 The main challenge in the future for both the Commission and Member States will be to find the right balance between the two.95 The dependence on gas from states outside the jurisdiction of the EU makes it even harder to find the right way towards greater long-term social welfare. Thus, long-term vertical contracts will be a priority of competition enforcement in the EU energy sector for many years to come.96

86 87

ibid 20. ibid 14. 88 Sector Inquiry 5. 89 ibid 58 f, 164. 90 Bellantuono 12. 91 ibid 13. 92 ibid 18. 93 ibid 32. 94 Talus 547548. 95 ibid. 96 Hauteclocque, Legal Uncertainty 15.

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Bibliography Legislation and Treaties Article 101 and 102 TFEU (Treaty of Lisbon) 2009 Third Energy Legislative Packet (in force from 03.03.2011) OJ L 211, 14 August 2009 Cases and Commission Decisions Distrigas [2007] COMP/B-1/37966 E.ON Ruhrgas [2006] Bundeskartellamt, 8. Beschlussabteilung, Bonn, 13 January 2006, B113/03 Competition Authorities Publications and Discussion Papers DG Competition Report on Energy Sector Inquiry, SEC (2006) 1724, 10 January 2007 DG Competition discussion paper on the application of Article 82 of the Treaty to exclusionary abuses, December 2005 DG Competition Guidelines on the application of Article 81(3) of the Treaty [2004] OJ C 101/97 Commission Notice on Guidelines on Vertical Restraints [2000] OJ C291/1 Bundeskartellamt, 8. Beschlussabteilung, B-113/03, Bonn, 28 January 2005, Kartellrechtliche Beurteilungsgrundstze zu langfristigen Gasvertrgen European Commission Antitrust Press Releases Commission Press Release MEMO/06/197, 16.05.2006 Commission Press Release MEMO/07/407, 11.10.2007 Books, Articles, etc. G. Bellantuono (2009) Contract law, regulation and competition in energy markets, 10,2 Competition and Regulation in Network Industries 159188 M. Bonacina, A. Creti, F. Manca (2008) Imperfectly competitive contract markets for electricity, 8 IEFE Working Paper P. Cameron, Competition in Energy Markets, Law and Regulation in the European Union (Second Edition, OUP, Oxford 2007) G. Coop, (2006) Long-term energy sale contracts and market liberalisation in new EU Member States Are they compatible? 2 International Energy Law & Taxation Review 64 71 A. Creti and B. Villeneuve (2008) Long-term Contracts and Take-or-Pay Clauses in Natural Gas Markets 13,1 Energy Studies Review

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C. Egenhofer, K. Gialoglou, D. Klackenberg, (2004) Rethinking the EU Regulatory Strategy for the Internal Energy Market 52 CEPS Task Force Report D. Finon and Y. Perez, (2008) Investment risk allocation in restructured electricity markets. The need of vertical arrangements 12 LARSEN Working Paper T. Gruber, (2007) Cross-Border Trade in Electricity and Gas. Obstacles to Effective Competition from a Regulatory Standpoint 8,3 ERA Forum 417426 A de Hauteclocque, (2009) Efficiency, Competition and Long-Term Contracts in Electricity Markets, Workshop organized by the Loyola de Palacio Program of the European University Institute and GIS LARSEN, Florence, 1516 January 2009 A de Hauteclocque, (2009) Long-term energy supply contracts in European competition policy: Fuzzy not crazy, 37 Energy Policy 53995407 A de Hauteclocque, (2008) EC Antitrust Enforcement in the Aftermath of the Energy Sector Inquiry: A Focus on Long-Term Supply Contracts in Electricity and Gas in B. Delvaux, M. Hunt, K. Talus, EU Energy Law and Policy Issues (ELRF Collection First Edition, Euroconfidentiel, Brussels 2008) A de Hauteclocque, (2008) Legal Uncertainty and Competition Policy in Deregulated Network Industries: The Case of Long-term Vertical Contracts in the EU Electricity Markets, Larsen Working Paper: No. 14 R. Meade and S. OConnor, (2009) Comparison of long-term contracts and vertical integration in decentralised electricity markets, LARSEN Working Paper: No. 26 K. Neuhoff and C. von Hirschhausen, (2005) Long-Term vs Short-Term Contracts: A European Perspective on Natural Gas 12 Globalization of Natural Gas Markets Working Papers A. Neumann and C. von Hirschhausen (2005) Long-Term Contracts for Natural Gas An Empirical Analysis, Globalization of Natural Gas Markets Working Paper: No.13 D. Newbery (2004) Privatising Network Industries, 1132 CESIFO Working Paper M. Roggenkamp Energy Law in Europe, National, EU and International Regulation (Second Edition, OUP, Oxford 2008) K. Talus (2007) Long-term gas agreements and security of supply between law and politics, 32,4 European Law Review 535548 H. Ungerer, (2007) Recent developments in the European Gas Sector A Competition Perspective, The 14th European Gas Conference, Oslo, 1416 May 2007 H. Weight (2009) A Review of Liberalization and Modelling of Electricity Markets 34 Electricity Markets Working Papers