In November 2002, the European Union (EU) energy commissioner, Loyola de Palacio, announced that an agreement had been reached between the energy ministers of the respective EU governments on the opening and eventual integration of the European gas and electricity markets.

Broadly, the extent to which the agreement and the EU directives that precede it will impact on the continental project finance market will largely depend on how vigorously the agreement is applied by the EU member states and in particular Germany and France. Moreover, in looking to the future, the experience of market deregulation in the UK provides a useful illustration of some of the possible effects of full liberalisation in the EU.
Deregulation

The commitment to integrate markets should be seen in the wider context of the EU's intention to reduce its growing reliance on imports to meet its energy needs. The safeguarding of energy supplies and the growth in the use of sustainable and renewable sources of energy are the two key principles dominating current EU energy policy.

Under the agreement each member state has committed to facilitate and permit:
> the market for commercial customers to be fully open by 2004;
>full market liberalisation for all customers (domestic and commercial) by 1 July, 2007;
> the legal separation and 'unbundling' of ownership and responsibility for national production, transmission and distribution assets.
Production and transmission assets are due to be unbundled by 1 July, 2004; and distribution assets are due to be unbundled by 1 July, 2007; and
>the creation of cross-border electricity exchanges and the development of interconnected electricity and gas networks in current member states and vital producers such as Russia (the Ten-e projects).

The agreement builds on the commitment made by European leaders at the Barcelona Summit in March 2002 to open domestic markets to competition for non-commercial customers by 1 July, 2004.

The agreement also restates the objectives underpinning the Electricity and Gas Directives issued by the European Commission (EC) in January 1997 and July 1998 respectively. The Electricity and Gas Directives – which sought to establish common rules for the generation, transmission and distribution in the EU – have been implemented with varying degrees of success by the current 15 EU member states.

The agreement is intended to accelerate the current rate of liberalisation in each of the national markets which are currently autonomous.

The proposed unbundling of national transmission and distribution assets is intended to remove a barrier to entry into key continental markets. By permitting third parties access to essential infrastructure assets such as high voltage grids and pipelines, it is hoped that competition to supply industrial and domestic consumers will be increased and cross-border flows of power and gas will be facilitated. The impact of the unbundling requirement on dominant European players such as Electricite de France, Gaz de France and EoN is qualified by the right for each member state to request the EC to permit that country to adopt alternative (and so far undefined) structures in light of the progress made by that country in implementing the agreement. This right, which is only exercisable after 2006, was a crucial concession agreed at the November meeting of energy ministers and a critical factor in allowing wider agreement to be reached.

Cross-border exchanges

The proposed introduction of cross-border electricity exchanges is a potentially critical measure in the development of a truly integrated European energy market. Currently the electricity exchanges in each EU member state are only concerned with the sale and purchase of electricity for delivery within or at the boundaries of that EU member state or the grid in question. Subject to the creation of sufficient interconnection capacity and the agreeing of appropriate tariff and congestion charging regulations, cross-border flows of energy offers should open up new markets for low cost producers and facilitate reductions in energy prices through the growth of pan-European energy trading.

A major boost to the future roll-out of cross-border electricity exchanges is the success of the series of master trading agreements agreed and adopted by key industry participants under the remit of the European Federation of Energy Traders (the Efet Agreements). The Efet Agreements are already well established as a basis upon which 'spot' trades executed through existing continental electricity exchanges are governed.

The UK's experience

Since the privatisation of the electricity industry in the UK in the early 1990s, generating and supply assets have been owned by UK, US, French and German utilities. The national transmission system has passed to the publicly listed and traded National Grid Transco Company.

Ownership of assets has since consolidated and the UK electricity and gas sectors are once again dominated by large vertically integrated (possessing generation and supply divisions) companies.

In addition to creating competition in the supply of electricity, the privatisation programme precipitated a major expansion of generating capacity in the 1990s, principally through the construction of independent gas-fired power stations financed on a limited recourse basis. Consequently, current
generating capacity in the UK generating sector is estimated to exceed demand by 30%.

More recently, the UK energy market has been further liberalised through the introduction of the New Electricity Trading Arrangements (Neta) in March 2001. In replacing the previous pool system, Neta represents a fundamental change to the basis upon which electricity is bought and sold in the UK and strongly favours flexible and reliable generating assets. Under Neta, trading counterparties are required to settle on a price for delivery of power at a future date rather than by reference to a pool price effectively set by generators.

Although wholesale prices have dropped by more than 40% since the introduction of Neta, the plunge in prices might be more accurately attributable to the 30% over-capacity in the generating sector.

Given the combined effects of inevitable plant outages and the possible mothballing or closure of plants, the current over-capacity could diminish relatively rapidly. The viability of merchant plants and other projects without secure off-take arrangements are now under scrutiny by rating agencies and lenders alike.

In addition, the difficulties currently being experienced by several energy companies, in particular those without retail hedges or with portfolios of less flexible and older plants, has been well publicised. Although decreases in wholesale prices were expected, neither the impact of the inherent volatility in market-determined prices nor the size of the price slump were fully anticipated.

The arrival of large-scale energy trading has required lenders, sponsors and advisers to become familiar with a complex and novel set of risks and regulations. Most importantly, as a means of making projects more bankable by insulating projects from price volatility, lenders are demanding higher levels of sponsor support with increased levels of structuring in the form of off-take, tolling, production sharing and other hedging arrangements.

The future role of project finance

The EC and the EU member states have undertaken to carry out substantial and politically challenging restructuring of key industries by specific deadlines. Although the extent to which each government is prepared, or is able, to commit sufficient resources to meet these considerable targets is yet to be determined, clearly capital expenditure will be considerable.

In recognition of the complexity and cost involved in delivering the Ten-e projects, the EC has announced that enhanced levels of funding support will be made available. To date, diverse project finance structures have been utilised, particularly in the form of public private partnerships, by several European Governments as a means of delivering new or upgrading existing assets in indigenous energy, infrastructure and transport sectors (see pages 38-39). As energy assets typically require continual investment over long periods of time, a gradual return to cohesively structured projects should help deliver more robust and sustainable projects.

With the exception of the 12 Ten-e projects already specified by the Commission, it is not yet clear what other specific projects will materialise as a consequence of deregulation. However, given the common experience of sponsors, investors and lenders in the UK market and California and taking into account the lessons learned since the collapse of Enron, certain broad observations on the future direction of project finance in the European energy market can be made.

These include, in the short to medium term, energy projects becoming more structured with lenders seeking increased sponsor support, shorter tenors, higher margins and more robust financial base cases with a return to traditional off-take arrangements.

As with the enhanced co-funding levels announced by the European Commission for the Ten-e projects, increased support from individual governments may be inevitable in order to promote renewable sources of energy. Such support could take the form of specific subsidies, concessions or tax incentives. In the UK, for example, windfarm operators have been granted exemptions from the Climate Change Levy and are seeking other concessions under Neta.

Both the financing of new projects and the restructuring and refinancing of existing energy assets will increasingly need to address the more stringent EU insolvency, trading, environmental and emissions standards. In addition, although the proposed extension of the EU Investment Services Directive and the 'Basle' criteria to the energy companies should lead to uniformly higher levels of operational and financial risk management, it may also affect investment activity by individual companies.

In an integrated market, jurisdictional differences on vital issues such as set-off, close out netting and contractual provisions governing the subordination of the competing interests of creditors to parent companies and subsidiary project companies will become increasingly important.

The increased importance of European energy trading arrangements is a logical development from the dual objectives of creating cross-border electricity exchanges and the building of the Ten-e networks. Increased interconnection between countries will allow energy trading firms to 'schedule' energy between countries and minimise operational risk by remaining in a balanced position. Although energy trading may continue to grow in terms of volume and complexity, it is unlikely to find substantial support among lenders as a sole means of providing revenue.

Participants in the area of project finance would do well to remain familiar with essential old school skills including risk allocation (as opposed to risk aversion) and financial modelling (as opposed to blind faith). Equally, an understanding of proven structures (including power purchase and other off-take agreements) and the complexities of the evolving European trading and regulatory environment will complement each other.

Accordingly, as the Agreement and the EU directives are implemented over the course of the next four years, it is fair to assume that a wide variety of new and challenging opportunities will arise.

Garrett Monaghan is a senior associate in the projects group in the London office of Dewey Ballantine. Adam Dann and James Simpson Jr, partners in the projects group, also provided input to the article.