Unbundling under the EU Third Energy Package – EU and UK reform - Oil, Gas & Electricity

Introduction and Summary

This article provides an overview of the unbundling obligations under the European Union ("E.U.") Third Energy Liberalisation Reform Package ("the Third Directive" or the "Third Package") as applied to Transmission System Operators ("TSOs") and describes the Great Britain ("GB") reforms to these rules, following a 2013 European Commission working paper.

The Third Directive, introduced by the Commission in 2009, actually comprises two directives: Directive 2009/72 concerning common rules for the internal market in electricity¹ (the "Electricity Directive"); and Directive 2009/73 concerning common rules for the internal market in natural gas² (the "Gas Directive"). E.U. Member States were required to implement the directives by 3 March 2011³ except for the provisions on unbundling TSOs, where Member States were given until 3 March 2012 for implementation.⁴

Unbundling Obligations for Transmission System Operators

The unbundling obligations under the Third Directive apply primarily to TSOs in the E.U.. TSO's include onshore and offshore electricity transmission, electricity interconnection, gas transmission and gas interconnection.

The primary objective of the unbundling rules is to ensure independence of electricity and gas transmission services from generation, production and supply in order to increase competition in E.U. energy markets.

Unbundling Options

The Third Directive states that a person controlling an electricity or gas transmission system must ensure that it is independent from any part of its business that produces gas or generates electricity. This applies across the gas and electricity businesses so that a person controlling an electricity transmission system must ensure that it is independent from gas production.⁵ E.U. Member States have three options for separating electricity generation and gas production, and supply of electricity and gas from TSOs:

Full Ownership Unbundling - this option requires that the same person or persons controlling TSOs are not entitled to directly, or indirectly, have any interest in companies which generate, produce or supply electricity or gas.⁶ This is the European Commission's preferred option and reflects its ideal of completely eliminating vertical integration involving transmission. In order to achieve this goal, the European Commission has required three vertically-integrated energy companies (E.ON, RWE and ENI) to be unbundled, alleging an abuse of a dominant position arising from the ownership of transmission networks.
Independent System Operator ("ISO") - under this option, the vertically-integrated company still owns the transmission network, but the operation of the network is carried out by an independent system operator appointed by the relevant E.U. Member State and approved by the European Commission.
Independent Transmission Operator ("ITO") - this is the lowest threshold for unbundling and allows for the ownership of the transmission network to remain with the vertically-integrated company but requires the company to comply with a number of rules aimed at ensuring the independence of its supply and generation businesses.

E.U. Member States were required to choose an unbundling option by 3 March 2012 and to adopt a legal framework in order to implement their chosen regulatory model. The regime adopted by GB (including offshore transmission), was the full ownership unbundling option with a few limited exceptions. All transmission systems that belonged to a vertically-integrated undertaking after 9 September 2009 (for example, GB offshore wind farm transmission cables) must be unbundled in accordance with the full ownership unbundling option.⁷ Once a Member State has chosen an unbundling option, unless covered by specific exemptions, TSOs can only operate under the chosen option and cannot choose a lower threshold of unbundling. The relevant Member State law that applies is the law where the transmission asset is located.

... THE COMMISSION'S WORKING PAPER ONLY PROVIDES GUIDANCE ON FULL OWNERSHIP UNBUNDLING AND DOES NOT AFFECT THE POSITION IN RELATION TO ISOS OR ITOS.

Concept of Control

As noted above, under the full ownership unbundling option the person or persons controlling a TSO cannot directly or indirectly have any interest in a supply, generation or production asset and vice-versa. In this regard, the Third Directive states that 'control' means rights, contracts or any other means which, either separately or in combination and having regard to the considerations of fact or law involved, confer the possibility of exercising decisive influence on an undertaking, in particular by:

ownership or the right to use all or part of the assets of an undertaking;
rights or contracts which confer decisive influence on the composition, voting or decisions of the organs of an undertaking.⁸

Effectively, the concept of 'control' of a TSO is the same as that found in the E.U. Merger Regulation and includes sole control, joint control, negative and positive control obtained either as a result of contractual rights or shareholdings.

Commission Working Paper on Full Ownership Unbundling

While the reasoning behind the full ownership unbundling rules are sound, a strict application of the rules can lead to absurd results. It will lead to a significant restriction on investors with multiple investments in the energy sector as investors who control transmission assets will not be able to have any interest in generation, production or supply assets and vice versa.

The Commission has, however, recognised that this absolute approach can have a disproportionate impact on financial investors who are, for instance, seeking a diversified portfolio within the energy sector. The working paper therefore explains that the Commission will seek to effect the underlying objective of the unbundling rules which is to remove any conflict of interest between generators, producers and suppliers on the one hand, and TSOs on the other. It is important to note that the Commission's working paper only provides guidance on full ownership unbundling and does not affect the position in relation to ISOs or ITOs. The working paper sets out the Commission's practice in a number of different case to show that it may take a more relaxed view of the full ownership unbundling when certain conditions were satisfied. Broadly speaking, these can be satisfied when:

The geographic location of the transmission asset and the roduction/supply asset are so far apart that there is no realistic possibility of discrimination. That is, there must be no interface between the transmission system and the production/supply asset – for example, when certifying National Grid, the Commission did not find it necessary to raise an objection on the basis that the TSO parent company, National Grid plc had generation interests in the U.S. and Australia;
Secondly, when the transmission asset and generation and production asset are of different energy types, that is if one is gas and the other is electricity – For example, in the certification of the Spanish TSO, Red Electrica de Espana, the Commission found there was no possibility of discrimination where the same investor controlling a gas transmission asset also controlled certain small coal-fired generation;
Thirdly, when the size and market share of the production/supply activities was very small – for example, in the Walney 1 certification the Commission approved the certification of the Walney 1 OFTO even though its parent Barclays and Mitsubishi had interests in a number of small generation plants in UK, Italy, France and Bulgaria.
Lastly, there are a number of other assorted factors which the Commission may take into account on a case-by case basis, these include: (1) if the energy production only a by-product of other activities; (2) if the energy generated sold at regulated prices; (3) if the production or generation activity has no effect on market prices; or (4) if there is financial regulation requiring ring-fencing in any case.

Reform in GB

Following the publication of the Commission's working paper, in September 2014 the UK Department for Energy and Climate Change ("DECC") published a consultation on reforming the unbundling rules applicable to GB TSOs, with a view to making them more investor friendly. The reformed rules are expected to be implemented in early 2015.⁹

DECC proposes to amend the ownership unbundling provisions of the Electricity Act 1989 and Gas Act 1986 to introduce further flexibility to Ofgem's consideration of certification cases that do not present a risk of discrimination, in the form of a new discretionary power to certify a TSO where each of the strict requirements of the unbundling rules may not be passed. DECC proposes that Ofgem will decide on a case by case basis whether, in its opinion, the relationship between the TSO or its controller and a producer or supplier may give rise to an ability and incentive for discriminatory behaviour. It will be for the TSO to expressly request Ofgem to consider exercising the proposed discretion and present supporting justifications. In exercising its discretion, Ofgem may take into account the following factors:

Types of TSO and producer/supplier involved.
The TSO's ability to control access to networks and to influence the commercial terms of connection.
The TSO's access to commercially sensitive network information.
The TSO's responsibility for system planning and development for the network activity.
The TSO's ability to influence the regulatory framework, e.g. the relevant industry codes and modification process.
Governance arrangements in place to separate business activities, including the flow of commercially sensitive information.
Geographic separation between the TSO and the producer/supplier, which may be indicated by the market power of the producer/supplier in a specific region, and/or the degree of interaction between the production/supply output and the transmission route.

The pragmatism demonstrated by the Commission and Ofgem provides a potential avenue for energy investors to obtain and maintain interests in European generation, supply and transmissions assets simultaneously. In principle, the Commission has indicated that such holdings are permissible as long as it can be demonstrated that there is no ability or incentive (and hence, no likelihood) for a TSO to discriminate in favour of its downstream generation or supply business. This criteria is likely to be satisfied, particularly in cases where there is no interface between the transmission business and the generation/ supply business and hence investors should be able to geographically diverse portfolio of E.U. energy assets. That said, there is still reason for caution for investors looking to have interests in both transmission and production or supply. This is for the following reasons:

First, the Commission has made it clear that its working paper only serves as guidance and is not legally binding. This means that any Commission, or national regulator's (e.g. Ofgem) decision taking too relaxed a view of the Third Directive could be overruled by the European Courts.

Second, a TSO is still required to bring to the national regulator's attention any development which could affect its certification. Each case be separately assessed and the burden of proof to show that there is no conflict of interest in an investor having stakes in both transmission and production/supply is on the TSO concerned.

Thirdly, the Commission and Ofgem have made it clear that no factor is decisive and a holistic view must be taken. This means that there are no overarching rules and being a small generator or not having an interface between transmission and generation will not necessarily preclude a conflict of interest on every occasion.

Finally, where the Commission has certified a TSO but a risk of conflict remains, the Commission will typically ask the national regulator to continue monitoring the situation and open a new certification procedure as soon as it has any concerns.

Investors should therefore not assume that their conflicting investments in generation/production/supply and transmission are automatically exempt from the application of the unbundling rules if one of the circumstances outlined above are met. If such a situation arises in the course of a transaction, it is recommended that the investor engages in early discussions with the Commission and relevant national regulator to understand the impact of the unbundling rules on the transaction.

Footnotes

¹ OJ 2009 L211/94.

² OJ 2009 L211/73.

³ Article 49, Directive 2009/72 and Article 54, Directive 2009/73.

⁴ Article 9, Directive 2009/72 and Directive 2009/73.

⁵ Article 9(3), Directive 2009/72 and Directive 2009/73.

⁶ Article 2(4), Directive 2009/72 and Directive 2009/73.

⁷ Commission staff working paper, Interpretative note on The Unbundling Regime, page 5.

⁸ Article 2(34), Directive 2009/72 and Article 2(36), Directive 2009/73.

⁹ See https://www.gov.uk/government/uploads/system/uploads/attachment_data/ file/354981/unbundling_call_4_comments.pdf

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

UK: Unbundling under the EU Third Energy Package – EU and UK reform