European network unbundling rules relaxed

There’s good news for infrastructure investors as the government softens the energy unbundling rules handed down from European directives, say Mark Jones and Alex Olive.

On 16 September 2014, the Department of Energy and Climate Change (Decc) published proposals to amend the UK’s implementation of the energy ownership unbundling rules, required by the EU Third Energy Package, to reflect the more liberal approach now being taken at European Union level.

The European Commission’s third package requires structural separation between transmission system operator activities (onshore gas and electricity transmission systems, offshore transmission lines and interconnectors) on the one hand, and generation, production and supply activities on the other.

The directives prevent a company that controls a transmission system operator – or has the right to appoint the members of its supervisory board – from controlling or even exercising any right over a generation, production or supply business, and vice versa.

The exercise of a right in this context includes the exercise of any voting rights and the power to appoint board members. The rules do not, however, prevent purely passive minority shareholdings, where there are no associated voting or appointment rights. The rules are enforced through a certification process undertaken by Ofgem and overseen by the Commission.

The purpose of these rules is to prevent conflicts of interest and opportunities to discriminate in favour of a company’s own affiliated businesses and against third party network users.

However, the directive’s stringent wording has led to a number of apparently unintended and unanticipated limitations on portfolio investments. This is a particularly unfortunate result given the EU’s recognised need to encourage investment in infrastructure.

The unbundling rules apply not only to shareholdings or influence within each of the electricity and gas markets but also across the two. Furthermore, the rules have no geographic limitations, such that conflicting interests in countries on different sides of the EU or even outside of Europe are technically prohibited. There is also no account taken of the physical distance between the businesses required to be unbundled, or the lack of a physical connection. Nor are there any “safe harbours” built into the regime. The potential chilling effect on investment activity has not been helped by the absence of a speedy process for seeking certification clearance.

These rules, when taken literally, have led to perverse outcomes, preventing investment in essentially unrelated activities, which even the European Commission did not wish to countenance in its transmission system operator certification reviews.

Thus, in May 2013, the Commission published much-awaited guidance on this issue.

The non-binding Staff Working Paper on unbundling recognised the difficulties that the rules have caused for holding companies of transmission operators and financial investors such as pension funds, insurance companies and infrastructure funds, which would typically have diversified portfolios.

In Staff Working Paper, the Commission confirmed the more pragmatic approach it has taken, in circumstances where the spirit if not the letter of the unbundling rules is satisfied – that is, where there is no risk of discrimination in practice.

Three scenarios the Commission has been comfortable with are shown in figure 1.

In the light of this, the UK government now believes that the UK’s transposition of the directives into national legislation is unnecessarily restrictive – that it unduly constrains investment where there is no foreseeable harm.

The government therefore proposes to introduce further flexibility to the country’s unbundling regime, in the form of a new discretionary power enabling Ofgem to certify a transmission system operator as compliant even where one or more of the five ownership unbundling tests is not passed, provided that it does not consider there to be a risk of discrimination in the circumstances.

The change, which should be widely welcomed, opens up potential for further investor participation – to the extent permitted by the pre-existing national licensing regime.

This is a strong signal of the government’s commitment to encouraging investment in UK energy markets. It was perhaps no coincidence that the government’s early plans for this were announced in the same month as its report on delivering UK energy investment.

However, the reform does not present an “open door” to investor participation. The proposed changes do not create an automatic exemption. Rather, emphasis is on the applicant’s ability to demonstrate a convincing lack of discrimination.

Ofgem can be expected to scrutinise the facts of each case closely and its decision must then be approved by the Commission. Ofgem guidance on this issue is expected and it should also be noted that the government proposes not to allow the discretionary power to be exercised in relation to an electricity transmission operator that is directly physically connected to a generator.

In such cases, the risk of discrimination is presumed (see figure 2 for scenarios where Ofgem will have no discretion).

 Responses to these proposals for new unbundling rules are invited by 14 October 2014, with the intention being for the new regulations to come into force in early 2015.

Northern Ireland’s regime is unaffected by the proposals.