Climbing the competition Pole

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Since 1989, successive Polish governments have struggled to restructure and modernise the energy sector. Legislation passed by the Sejm, the lower house of Parliament, in December 1997 was supposed to put the country on track for competition in the wholesale and retail power markets, the introduction of third-party access to transmission grids and greater efficiency within the energy market as a whole. But while more than 30% of electricity in Poland is in theory freely traded, there remain major obstacles to real market liberalisation.

The electricity market is highly fragmented, with about 30 generating companies and 33 distribution companies. Between 75% and 85% of these are state-owned, as is the grid operator, Polskie Sieci Elektroenergetyczne (PSE). Coal – both hard coal and lignite (brown coal) – meets 95% of Polish power market needs.

Miroslaw Duda, director of competition at Warsaw-based energy regulator Urzad Regulacji Energetyki (URE), says: “The coal industry is a huge burden on the state budget. The cost of restructuring is high. But no-one knows how to restructure without creating more social problems, due to the concentration of mining in one region [the south west].”

But the coal industry is one of the strongest lobbies in Poland. The state of the power generation sector – which lacks competition and privatisation – is a result of the rigidity of the coal industry. “Any changes in the electricity market will affect the coal industry,” says Josef Pospisil, a London-based analyst at credit rating agency Fitch Ratings. At present, Polish power generators pay nearly twice the usual world price for domestically produced coal.

Current rules for third-party access apply to customers buying more than 10 gigawatt hours (GWh) annually – which will cover only major end-users. But so far only a handful of eligible customers have switched suppliers, as local distribution firms have been allowed by the regulator to inflate the access tariffs for to their grids. Jarek Astramowicz, president of Warsaw-based energy trader JAC Entra, says transmission costs that should be around 2–4 zlotys per megawatt hour (MWh) have been pushed up to 30–50 zlotys per MWh ($1=4.14 zlotys). Such cost inflation directly affects industrial users, he adds.

Single-buyer concept
The PSE operates effectively as a single buyer of the bulk of power from generators and is the main supplier of power to distribution companies. The grid operator also monopolises all imports and exports of electricity, owns generation and distribution assets and has been seeking to diversify into other markets, such as telecommunications.

However, the URE’s Duda says: “The single-buyer concept is no longer valid under EU competition law, so the PSE is to be unbundled from its other activities [except transmission].” But the grid operator still remains a party to power purchase agreements (PPAs) signed with generators and coal mines in the mid-1990s. These long-term contracts cover 55–60% of the electricity market and secure bank loans for the generators for plant modernisation and the incorporation of environmental controls.

The Polish government feels the PPAs hold back market deregulation because they lock-in power prices for a big section of the market up to 2010–2015. In addition, the contracts stipulate power prices for generators that are higher than those in today’s market by around 30 zlotys per MWh, specifically to permit them a sufficient return and debt amortisation.

Under a plan first floated by the government in mid-2002, the PSE aims to sell up to $2 billion of securities backed by surcharges on consumer electricity bills. The receipts from these will be used to buy out the PPAs and thereby enable generators to pay off their bank loans and contract new agreements with distributors. The upshot, the government hopes, would be greater liquidity in the electricity market.

In addition to the near-60% market share covered by PPAs, cogeneration1 obligations represent some 6% of the market, while similar renewable energy obligations hold a further 2%. “The rest [around 30%] is in the competitive market,” says Duda. JAC Entra’s Astramowicz says total annual power consumption in the market is equivalent to $4 billion, meaning some $1 billion of electricity is traded freely. The country’s power exchange, Gielda Energii, traded some 3% of total consumption in February, while the remainder of the competitive power was traded over-the-counter.

The official plan is that those kilowatt hours freed up from the securitisation deal would be traded on the power exchange, boosting its liquidity. But an executive from one foreign company hoping to acquire a trading presence in the Polish market says new entrants will still have difficulty establishing themselves. “All we have seen are contracts between generators and regional distributors, where a trader holds the position of an intermediary,” he says. “There is nothing special in it.”

While there were some smaller OTC contracts available last year, he adds, this year they have been scarce. He believes the only sell-side advantage for newcomers in Poland will lie in cross-border trading, once it is no longer the exclusive remit of the PSE.

Jacek Brandt, vice-president of the Polish power exchange, remains optimistic that the problems with the PPAs will be resolved by the end of this year. He says: “This problem should not be a negative influence on the market, but it is a chance for market growth.” Brandt acknowledges that there is a shortage of traders in the Polish energy market.

Yet existing traders such as JAC Entra, which developed from a management buyout of the trading interests of Enron Poland, are optimistic. The company has been conducting one-and-a-half-hour trading sessions in the day-ahead market since 29 January. The company is not competing for end-users, but trades on the wholesale market both as an intermediary and on its own account.

Meanwhile, the government has yet to announce full details of the securitisation plan. But Dariusz Turek, a senior associate at the Warsaw office of global law firm Clifford Chance, says one of the first steps would be to introduce a new law containing a special provision to dissolve the PPAs as of a particular date. As compensation, the generators would receive a one-off payment based on the difference between their asset values with the PPAs and their asset values without the PPAs. A special company would have to be created to collect the surcharges on electricity bills that would fund this compensation, and an offshore special-purpose vehicle would have to be created to issue bonds. The whole exercise could be carried out in one or more tranches, Turek says.

Opposition to securitisation
The securitisation plan has attracted considerable criticism. “The government has to guarantee these bonds and will need approval from the legislators,” says Wladyslaw Mielczarski, professor at the Technical University of Lodz and adviser to Katowice-based energy consultancy Energo System. “There is little chance for this to be approved.” He also notes the deal would involve large transaction costs. Some market participants have suggested these could be as much as 9% of the total deal value.

Most of the power generators are opposed to the plan as they stand to lose guaranteed tariffs, and the banks are reluctant to lose their security. But traders such as JAC Entra’s Astramowicz are also against it. “Long-term contracts – if left alone – would do no harm,” he says, adding that the power prices stipulated in the current contracts are falling. Power prices were higher for the first three to five years of these contracts to help generators amortise their debts, he says. And in any case, Astramowicz adds, they only cover some 55% of the electricity market.

In any case, he says, a government action that breaches existing contracts such as the PPAs would be a violation of Poland’s civil code, which includes a provision on sanctity of contract. Should the Polish parliament pass a law that in effect violates the civil code, this would rupture existing constitutional guarantees, Astramowicz says.

What’s more, there is no certainty as to what the PSE would be able to do with the money it collects. “There are no legal grounds on which the PSE could transfer money to another bank account,” he adds.

Finally, the deal could also be subject to VAT at 22%. This tax issue effectively halted an earlier attempt to dissolve the PPAs and compensate for them through a charge on consumer tariffs.

Consolidation
Meanwhile, provoking further controversy are government plans to promote consolidation of the electricity sector, partly to create bigger national energy companies and partly to offset the high costs associated with coal mining and coal-fired power generation. Take Polski Koncern Energetyczny (PKE), a generator that owns several power plants and coal mines in southwest Poland, which now accounts for 25% of the market and is a major regional power. Its existence flies in the face of market liberalisation, and critics say it has done nothing to alleviate the economic and social problems associated with the coal industry on which it is based.

The government’s next plan is to merge the 4,340MW Belchatow plant with plants at Opole (1,700MW) and Turow (1,100MW) – together with two coal mines – into a corporate entity to be known as BOT. The Technical University of Lodz’s Mielczarski says the thinking behind this is that because Belchatow’s capital costs were written off by previous governments, its power production costs are cheaper than those at the other two plants. This form of cost sharing will enable the plants to survive as a joint entity, he adds. But the coal industry trade unions fiercely oppose this plan, fearing significant job losses.

There is a further contradiction in government policy, says Astramowicz, since this method of consolidating the energy market also perpetuates existing cross-subsidies, as the cheaper generators will subsidise expensive and inefficient coal mines. The URE’s Duda admits that the elimination of cross-subsidies is difficult, particularly because of the way higher power tariffs charged to industry subsidise residential tariffs.

But in February, the government said that Belchatow’s existing PPA with the PSE – which expires in 2005 – could be extended, possibly up to the expiry of PPAs held by Opole and Turow, respectively in 2012 and 2015, with the grid operator. JAC Entra’s Astramowicz says this suggestion of delaying the entry of more than 4,000MW into the open market is yet another contradiction of the government’s stated aim to promote competition.

Meanwhile, government plans to consolidate distribution companies into five regional entities – unless individual distribution firms can be privatised first – also face a long gestation period. In October last year, German multi-utility RWE bought an 85% stake in Stoen, a distribution utility serving the Warsaw area, for 1.5 billion zlotys. But talks with German utility E.on for the sale of G-8, which owns distribution utilities serving northern Poland, collapsed last year due to pricing issues. The government maintains that the group will be privatised eventually.

Part of the attraction of such a deal for private-sector investors has been that the distribution utilities come with captive local clients – that is, large industrial users. But fears that market liberalisation will free up those captive clients to choose their own suppliers and endanger the utilities’ regional clout have placed yet another barrier in the way of developing electricity market competition.
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