On 19 September, the Commission announced its third legislative package aimed at liberalising the EU’s electricity and gas markets. It takes the form of two draft directives amending the current gas and electricity directives; two draft regulations amending the current regulations governing third party access to natural gas transmission networks and the network for crossborder exchanges in electricity; and, finally, a draft regulation establishing an agency for the co-operation of energy regulators.
The Commission’s continued push for ownership unbundling remains controversial. Further, the Commission’s approach to acquisitions by non-EU companies has led some (Russian) quarters to allege that the Commission is creating a fortress Europe running counter to the spirit of globalisation. Behind these headline-grabbing issues, the package contains significant moves to secure more effective regulation of the energy sector, including the creation of a supranational European agency, as well as greater transparency and consumer protection measures.

The Commission aims to have its package adopted towards the end of 2008. Meanwhile, it will listen closely to the discussion generated by its plans. Each of its proposals requires a robust debate within the context of various interrelated policy areas, particularly those of competition, free movement, security (of supply) and environmental objectives.
This article provides a brief overview of the unbundling and ISO proposals contained in the third package (as it applies to EU companies). In September, the Commission president, Jose Barroso, remarked that a “quantum leap forward” is required and that “this time we must get it right; consumers must no longer pay the price”. Despite the robust language, the most striking aspect of the third package is the Commission’s apparent retreat on requiring (outright) vertically integrated energy companies to unbundle the ownership of the (gas / electricity) transmission network from generation / production and supply.

Background
The third package follows a Commission inquiry as to why the EU’s gas and electricity sectors are still dominated by preliberalisation monopolies. In its January 2007 report, the Commission broadly concluded that there were five central issues preventing a truly competitive EU energy market: (1) high market concentration; (2) vertical foreclosure; (3) lack of market integration; (4) lack of transparency on energy markets, leading to (5) distrust in price formation mechanisms. The Commission’s consistent line in the January report, and in its subsequent energy roadshow, is that only ownership unbundling presents a regulatory efficient solution to the problems generated by national vertically integrated energy companies.

Increasing the pace of unbundling
The first generation gas and electricity liberalisation directives provided third parties with regulated or negotiated access to the networks and required accounting unbundling (separate account-keeping for the distribution and transmission businesses). They also required a degree of information unbundling, specifically the setting up of Chinese walls between the information obtained in the course of the network and, on the other hand, the supply businesses. An additional requirement of independence in management terms was imposed on transmission operators of electricity grids.

The second (and current) energy package goes further and requires vertically integrated companies to create separate legal entities for network activities (legal unbundling) and ensure separate executive management and decision-making with respect to its operation, maintenance and development (functional unbundling). Additional obligations are placed on energy companies to set up compliance programmes and to comply with general non-discrimination requirements.

What the Commission found in its energy inquiry was that the current provisions are not sufficient to ensure a competitive market. In particular, it considered the current rules could not remedy three major problems arising from joint ownership of network and supply businesses: (1) there is discrimination in access to infrastructure; (2) there is information leakage, with limits as to how far Chinese walls can actually achieve their function on the ground; and (3) under present structures, investment incentives are badly distorted with the risk that transmission investment decisions reflect what is best for the group as a whole, not the network.

Ownership unbundling
The Commission’s proposals would require member states to designate the transmission system owner as the transmission system operator, subject to the satisfaction of the ownership unbundling requirements.
Under the unbundling requirements, the same person will not (at both a national and EU level):

• be able to have direct/indirect control (the definition of which broadly follows that in the ECMR) of a supply/production undertaking (SPU) and direct/indirect control, or any right over or hold any interest in –collectively, “ownership interests”– a transmission system operator/a transmission system (TSOTS), and vice-versa (“interests” and “rights” include even the right to obtain dividends or other shares of the benefits);

 • be entitled to appoint members of the supervisory / administrative board of a TSOTS, and to have ownership interests in an SPU;

 • be entitled to be a member of the supervisory / administrative board of both an SPU and a TSOTS.

The third package does not demand the ownership unbundling of distribution networks as well, calling instead for the legal and functional unbundling rules currently in place for distribution networks to be “more clearly defined, properly implemented and closely monitored”.

Softening the blow of unbundling
However, the third package does allow for the ISO model. To be granted as a derogation from ownership unbundling by a member state, this model allows vertically integrated companies, existing at the time the relevant directive comes into force, to retain network ownership, provided that the assets are actually operated by a company or body completely independent from it – the ISO. Currently, a member state will designate an ISO further to a proposal from a network owner (a TSO) and subject to subsequent ommission approval.

The main objective is to ensure that the ISO solution is as effective as ownership unbundling. In particular, the independence of the ISO would be guaranteed by application of the ownership unbundling criteria to it, vis-à-vis generation and supply activities; and a TSO, which is part of a vertically integrated undertaking, is to be functionally and legally unbundled from other activities not relating to transmission.

The Commission also envisages the ISO having wide-ranging powers to operate the network and to decide on necessary investments, subject to regulatory approval.

In relation to network development, an ISO must promise to comply with a 10-year network development plan proposed by the
national regulatory authority, and demonstrate that it has the necessary resources to carry out various specified objectives. These include a general duty to operate, maintain and develop a secure, reliable and efficient transmission system (with due regard to the environment). In turn, a TSO would be under an obligation to finance transmission network investments decided on by the ISO and approved (after consultation) by the national regulatory authority, or give its agreement to financing by interested parties, including the ISO.

A political and legal compromise
The presence of the ISO model in the third package is no surprise. Politically, both France and Germany remain opposed to ownership unbundling and, as the Commission aims to have the third package adopted during the French presidency, a political compromise was almost inevitable.

Legal challenge to a singular requirement of ownership unbundling was also likely. The German government, for one, suggested that forced ownership unbundling might breach national constitutional property rights, and a major German energy company has repeatedly signalled its view that it would amount to an “expropriation” of shareholder assets. Of course, supremacy of EC law over a national constitutional law, and Germany’s in particular, is well established. Further, there is nothing in principle under EC law to prevent expropriation, provided that, in particular, the principle of proportionality is respected. However, legal challenge at the national level, even if ultimately unsuccessful, could have delayed the substantive implementation of the third package for quite some time.

A potentially more significant legal obstacle to ownership unbundling is article 295 EC, which says that the EC treaty is in no way to prejudice the rules in member states governing the system of property ownership. The Commission’s view is that article 295 issues could be avoided by allowing the retention in public hands of both network and supply/production, provided that sufficient structural separation is achieved. For example, the separated businesses are independently run by two different ministries, or one business is run by municipalities and the other by the state.

Obviously, one can question the practicalities of this solution and whether it would ensure sufficient separation to equate to ownership unbundling. In fact, while unlikely to prevent ownership unbundling outright, article 295 EC may well prevent the forced privatisation of state-owned electricity assets, which full ownership unbundling would require in certain member states. Attempts by the Commission to promote ownership unbundling in those member states where energy assets are already in private hands  could be viewed as discriminatory and unlawful as they would lead to an uneven playing field for competing public and private operators.

The ISO model would appear to offer the Commission a way out of this legal conundrum. Now the member states have a choice between ownership unbundling and the ISO model, the Commission is, prima facie, able to sidestep expropriation, article 295 and other potential legal arguments against it based on free movement law. There is the added bonus that the very existence of the ISO derogation would support an argument that it has acted proportionately and in accordance with the principle of subsidiarity.

A Scottish solution to a continental problem?
The best-known example in the EU of the ISO model is Scotland where, since 2005, National Grid operates the networks of the two vertically integrated electricity companies, Scottish Power and Scottish and Southern Energy. Undoubtedly the genesis for the Commission’s ISO model can be found in systems such as Scotland’s. However, it would be simplistic to assume that it slavishly follows any particular system. There are key differences, for instance, between the Commission’s proposals and the Scottish ISO model. In particular, the former would appear to reduce the TSO’s role largely to one of a funder, whereas, in Scotland, the TSOs are involved in network planning and maintenance.

Accordingly, the UK government/Ofgem will need to assess carefully how the package could impact on the UK’s statutory and regulatory framework and what changes it may require, not just in relation to network codes and licence conditions but also to primary legislation. At a high level, the Scottish system developed incrementally, reflecting the progress of privatisation and UK liberalisation; parachuting the ISO model into jurisdictions which have no history of the model, with the extensive regulation it involves, may simply prove not to be workable. Indeed, one can sympathise with the view that the ISO model is not really a practical alternative at all and that ownership unbundling may prove more attractive for government and industry players than, as one commentator put it, a slow death by intense regulation.

Of course, this may well have been the Commission’s intention. However, should the proposed ISO model turn out to be unworkable and to compare unfavourably with current ISO systems, with the corresponding impact on the potential proportionality of the legislation, the Commission’s legal sidestep may prove to be one into a legal and political wall.

* Both lawyers (Sebastian McMichael and David Laurie) specialise in competition and regulatory law with Shepherd and Wedderburn LLP