The creation and securitization of public debt in the Spanish electric sector by Luciano Figari

“The creation and securitization of public debt in the Spanish electric sector”

Student: Luciano Figari Reference number: 604636 Supervisor: Jan Toporowski Word count: 7,956 This dissertation is submitted in partial fulfilment of the requirements for the degree of Master of Science in Finance and Development of the School of Oriental and African Studies (University of London).

Declaration Statement I have read and understood regulations 17.9 of the Regulations for students of the School of Oriental and African Studies concerning plagiarism (see below*).I undertake that all material presented for examination is my own work and has not been written for me, in whole or in part by any other person. I undertake that any quotation or paraphrase from the published or unpublished work of another person has been duly acknowledged in the work which I now present for examination. I understand that I must have prior approval before incorporating any coursework I have completed for any previous qualification either at SOAS or elsewhere, and that any such previous coursework is duly acknowledged in the dissertation now submitted. I give permission for a copy of my dissertation to be held for reference, at the Schoolâ&#x20AC;&#x2122;s discretion. London, 9th September 2015, Luciano Figari, 604636.

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Table of Contents: “The creation and securitization of public debt in the Spanish electric sector” §

Abstract…6

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Section 1 Introduction: The creation of public debt in the Spanish electric sector…7

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Section 2: Antecedents…8 2.1 Prices below costs…8 2.2 Nuclear Moratorium…10 2.3 Competition Transition Costs…15

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Section 3: The tariff deficit…18 3.1 Definition and evolution…18 3.2 A guarantee from the State…21 3.3 A subsidy…22

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Section 4: Factors influencing the tariff deficit…24 4.1 Falling demand…24 4.2 Overinvestment…26 4.3 Market structure and oligopoly…28 4.4 Price formation process…32 4.4.1 Daily bids…32 4.4.2 The speculative use of derivatives in the Cesur bids…33 4.5 Conflicts of interest…34 4.6 The electric connections of the Spanish politicians, lobbying pressures and revolving door…36 4.7 The ambivalent impact of renewable energy…38

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Section 5: Consequences…39 5.1 Impact on the renewable energy sector…39 5.2 Public finances…40 5.3 Distribution effects and energy poverty…41

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Section 6: Conclusion…42

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Appendix: Country energy profile…43

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References…45

Figures Figure 1 Tariff deficit 2000-2013 (Million €)…17 Figure 2 Accumulated tariff deficit 2000-2013 (Million €)…18 Figure 3 Fundamental income and expenditure balances…20 Figure 4 Interannual electricity demand growth 2003-2013…23 Figure 5 Forecasted electricity demand growth 2000-2016…24 Figure 6 Installed capacity of combined cycles 2002-2013…25 Figure 7 Merger and acquisitions activity from 1983…27 Figure 8 Installed power capacity…41 Figure 9 Electricity prices for domestic consumers including all taxes and levies (€/KWh)…42 Figure 10 Electricity prices for industrial consumers including taxes (€/KWh)…42

Tables Table 1 Electricity prices 1973-1984…7 Table 2 Compensation of the nuclear moratorium…10 Table 3 Percentage of the electric tariff destined to the nuclear moratorium…11 Table 4 Financing of the costs of the nuclear moratorium…12 Table 5 Distribution of the CTC among generation companies…14 Table 6 Structure of the electricity holding groups…29 Table 7 Ownership structure of the electricity companies…33 Table 8 Electric connections of Spanish politicians…36

List of abbreviations and translations GDP - Gross Domestic Product…7 CPI - Consumer Price Index...9 Stable Legal Framework, Marco Legal Estable…10 US - United States…10 CNMC - Comisión Nacional de los Mercados y la Competencia, National Commission of Markets and Competition (regulatory authorities)…11 Fondo de Activos Resultantes de la moratoria nuclear, Securitization of Assets of the Nuclear Moratorium fund…13 TdA - Titulización de activos, Sociedad Gestora de Fondos de Titulización, S.A, Asset secturitization, Securities Fund Managing Society….14 ICO Instituto de Crédito Oficial, Official Institute of Credit …14 CTC – Costes de transición a la competencia, Competition Transition Costs…15 KW – kilowatts hours…16 FADE - Fondo de Amortización del Deficit Tarifario, Tariff deficit amortization fund…21 TWh – terawatts hours…25 MW – megawatts…26 Sedigas - Asociación Española del Gas, Spanish Gas Association…27 REE – Red Eléctrica Española, Electric Spanish Network…31 TUR – Tarifa de Úlltimo Recurso, Last Resource Tariff…33

Abstract This paper engages in a classical political economy discussion of the creation and securitization of public debt in the Spanish electric sector. Public debt is created in the Spanish electric sector when the revenues from the electric tariff are smaller than the recognized costs of the electric system. This debt is financed by electricity companies, that have securitized the receivables and sold them to investors as bond-like instruments.

This paper argues that this debt, which is known as the tariff deficit, is in effect a subsidy from the State to the electricity companies. The subsidy is financed with claims on a percentage of the electric tariff of consumers. Because of the inelasticity of demand of electricity, charging consumers for the tariff deficit is in effect an unconventional tax-collection tool of the State. By using this mechanism the Government moves off its balance sheet the subsidy, improving its balance sheet structure and reducing its official public debt levels.

“Energy is the next bubble” Gordon Gekko, Wall Street 2: Money Never Sleeps §

Section 1 Introduction: The creation of public debt in the Spanish electric sector

Debt creation occurs in the Spanish electric sector when the total revenues of the electric tariff are smaller than the total recognized costs of the electric system. The debt, known as tariff deficit, is temporarily financed by the country’s five largest generation companies, that have securitized the debt and sold it to financial institutions in financial markets as bond-like instruments. The initial debt, which is guaranteed by the public budget of the Spanish Government, has increased for a number of reasons that are explained throughout this paper. Over the years more than 40,000 million euros in debt were created in the Spanish electric sector and the outstanding tariff deficit is currently around 3% of Spain’s GDP. The academic literature on the tariff deficit is not vast. Most of the existent literature on the tariff deficit explains the concept and the phenomenon of debt creation in the electric sector without discussing whether the debt is public or private. Only Lopez (2013) mentions briefly that the tariff deficit is a non-recognized structural deficit but does not go any further into this idea. The published material tends to be more technical and descriptive (Alonso 2012; Rosa 2013), explaining the structure of the market process and its institutions, rather than analytical. Some of the literature is more focused on the law (Rincon 2003) and regulatory (Blazquez Gomez 2008) aspects of the phenomenon rather than on its economic aspects. Furthermore, an important part of the literature aims more to offer a list of possible solutions to the problem rather than analyzing it in a systematical and structural way (Fabra and Fabra 2012). None of the current literature has ever mentioned that the tariff deficit is in fact a subsidy from the State to the electricity generation companies to ensure their

profitability. According to this paper, the way in which the tariff deficit is financed reveals that it is in effect a subsidy paid by consumers with an unconventional taxcollection tool of the State. The Government uses the electric tariff as a tax-collection mechanism when it includes in the electric tariff of the consumers a percentage that is used to pay for the debt of the tariff deficit. In this way, the Government sector manipulates its balance sheet and pretends to have a lower public debt. This conclusion is certainly one of the main contributions of this paper to the existent literature. Additionally, this paper is the first one in including the practice of fixing electricity prices below the production costs during the years of the dictatorship as the first antecedent of debt creation in the Spanish electric sector. Furthermore, this paper pays a particular attention to the financial processes related to the creation of public debt in the Spanish electric sector. At the same time, it highlights the high level of market concentration that the electric sector has and explains how this structure can increase substantially the tariff deficit.

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Section 2: Antecedents

2.1 Prices below costs Until the oil crisis of 1973 the global trend was to subsidize energy costs in the belief that this stimulated economic activity. With the oil crisis the mindset changed and experts recommended that energy prices should collect its production costs in order to encourage a rational use of energy and an efficient resource allocation. This was not the case in Spain. Until 1978 the country was ruled by a dictatorship that determined the tariffs. Private and public electric companies coexisted. Because the priority of the government was to contain inflation, despite electricity prices were raised several times, the increases were not sufficient to cover the

production costs of electric companies. The following graph shows how the electric tariff increases were kept below the Consumer Price Index (CPI) for more than 10 years (Ibeas 2011: 21):

During the first years of democracy the energy policy remained unchanged and, as a result, the Spanish electric companies accumulated a large debt. The solution to the problem came with a wave of privatizations and a major financial restructuration, with several mergers and acquisitions being made, increasing substantially the market concentration.

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This is the first antecedent of electricity prices being hold below their production costs, which is one of the main reasons why public debt has been created in the electric sector from the year 2000 to 2014. With the change to a socialist government in 1983 a new pricing policy was established. The new system, known as the Stable Legal Framework, supervised the activities of private electricity companies by auditing their accounts and fixing an electric tariff that covered costs and established their profit margin. In this way, the return on capital and an adequate allocation for depreciation for electric companies was ensured. The Stable Legal Framework remained until 1997, when the sector was liberalized.

2.2 Nuclear moratorium In the 1970s, when the country was still ruled by a dictatorship, electric companies planned to build up to 25 nuclear plants in Spain. Their investment plans were based on forecasts of electricity demand that changed dramatically after the oil crisis of 1973. The construction of a nuclear plant can take as long as 10 years and it requires high initial costs. When the oil crisis burst the works had already been initiated and investments had been made. An important part of the financing of the nuclear plants was nominated in US Dollars, and inflation in Spain surged to two digits, boosting the financing costs. The combination of falling demand with increasing financial costs got the electric companies into a crisis of over-investment and some of them where close to going bankrupt. With the objective of adjusting the electricity supply to actual demand,

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the Government ordered a moratorium on the construction of five nuclear plants (Lemóniz I and II, Valdecaballeros I and II and Trillo II) in 1983. It was not until 1994 that the Government recognized that electric companies had right to economic compensations for their investments in these five nuclear plants. The Government determined that the funds for the compensation of the electric companies would come from a percentage of the electric tariff paid by consumers. In the words of the former Minister of Energy, who was in charge during that period (Eguiagaray, 2008: 39), “the public sector had to bailout the electric companies that had embarked on a pharaonic investment process derived from a delirious planning that was in absolute contradiction with the needs of the electric demand in Spain”. The bailout of 1994 may have created expectations in electric companies of further bailouts in cases of overinvestment, raising concerns about moral hazard. The Spanish electric sector currently has a generation over-capacity problem because there was over-investment in the years prior to the global financial crisis of 2008. According to the law 40/1994, the freezing of the construction of nuclear plants caused 4,383.24 million euros in economic losses to the electric companies. The compensation amounts by nuclear plant and companies were distributed in the following way (CNMC 2014: 2):

The royal decree 2002 of the year 1995, of December 28th, dictated that 3.54% of the revenues of the electric tariff should be used to compensate electric companies for the nuclear moratorium. The established time limit for the compensation was of 25 years, so as the impact on the electric tariff would not be excessive. From 2005 onwards the percentage diminished as the outstanding amount had been reduced with previous payments. The following table shows the percentage of the revenues of the electric tariff that were destined to compensate the electric companies (CNMC, 2014: 14):

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In total, the bailout of the electric sector costed electricity consumers 5,717.91 million euros, of which 1,334 million euros were destined to pay interests (Monforte, 2015). Interest rates had to be paid by consumers because the electric sector law 54/1997 allowed electric companies to sell the rights of the compensation of the nuclear moratorium to third parties. In other words, the stream of future payments of the

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electricity consumers were securitized and sold to financial institutions as fixed-income financial instruments. To that end, the Government ordered the creation of the Securitization of Assets of the Nuclear Moratorioum fund on the 4th of July of 1996. The Fondo de Titulización de activos resultantes de la moratoria nuclear is managed by Titulización de Activos, Sociedad Gestora de Fondos de Titulización, S.A., (TdA), an interministerial commission presided by the Spanish Secretary of State of Energy. TDA is registered as a private company specialized in providing asset securitisation related services and receives a fixed annual commission from the State for serving this purpose exclusively. The creation of the fund was financed with the issuance of bonds and two loans that were eventually paid by electricity consumers (CNMC, 2014: 4):

When the fund was created in 1996, the electric companies received 4,278.18 million euros for the receivables of the nuclear moratorium. By selling the receivables of the nuclear moratorium to the fund, the electric companies replaced the receivables by a cash equivalent, improving the quality of their balance sheet structures and consequently their credit rating scores. Furthermore, they did not have to wait until they received the payments. On the other hand, by allowing this measure the Government lost the ability to determine the percentage of the electric tariff destined to cover the

nuclear moratorium. In 2006 the State-owned Official Institute of Credit created a credit line to guarantee that the fund will meet the full amount of its payment obligations in each maturity date (Ernst & Young, 2014: 11). On October 10th of 2015 it is expected that the fund will be liquidated after receiving the last payment for the rights to the compensation of the nuclear moratorium. Paradoxically, the Electric Sector Law of 1997 allowed again the construction of nuclear plants. However, no new nuclear plants have been built in Spain since the nuclear moratorium was approved due to the high initial investment requirements and the legal uncertainty originated by the regulatory changes.

2.3 Competition Transition Costs Until 2006 Spanish electric companies received the “Competition Transition Costs” (Costes de Transición a la Competencia CTC), an economic compensation that was justified on the possibility that after the liberalization process their revenues could be lower than what was guaranteed under the Stable Legal Framework. When the electric sector law was approved in 1997 the expectation was that the creation of a competitive wholesale electricity market would reduce prices, resulting in lower revenues for generation companies. Furthermore, it was believed that new and more efficient power plants were going to be built, what would render inoperative the existing power plants. One of the main problems if this occurred was that generation companies would have been unable to recover sank costs from these facilities. Thus, the objective of the CTC was to guarantee the recovery of the investments made by firms in generation facilities and that their profits would not be affected by risk or uncertainty situations derived from the modification of the regulatory framework. Again, the Government

decided that the CTC would be funded with a percentage of the revenues of the electric tariff, in a similar way as had happened with the nuclear moratorium. In other words, the costs of legal uncertainty were transferred from the electric companies to the consumers. In total, 11,979 million euros were recognized to the electricity generation companies as costs that they had for transitioning from a regulated to a competitive market. The value of the CTC was calculated as the difference between the accounting net value of the generation assets built prior to the liberalization process and their actual market value. In order to determine the market value a market reference price was established, which was calculated as the installation and operational costs of an optimal electricity generation park with enough capacity to cover the demand of the Spanish consumers with a security margin of 10%. Furthermore, it was assumed that the average price of electricity in the wholesale market was going to be equal to the average total costs of each KWh. In microeconomic terms, it was assumed that the electricity market was in perfect competition, what never occurred as we will later see. Besides, it was assumed that the new power plants built after the liberalization process would cover the expected demand growth and that the old facilities would not increase their production (Lopez Milla, 2000). Ultimately, the new power plants were expected to substitute the old ones if a competitive market was established. The Competition Transition Costs (CTC) were distributed according to the generation capacity of each company in the following way:

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What happened after the liberalization process was exactly the opposite of what had been expected. Instead of going down, the prices of electricity went up year after year. Consequently, generation companies sold electricity at a price that was higher than the market reference price which was considered necessary to guarantee their revenues and profitability. Besides, as the international price of oil went up, so did the prices of gas, which was used as a raw material for the production of electricity in the new and allegedly more competitive power plants. Thus, the old plants which mainly used coal â&#x20AC;&#x201C; that was cheaper than gas- operated many hours per day. The technical forecasts of the liberalization process had been done wrong (Lopez Martinez, 2013: 117). In 2006 the Royal Decree 7/2006 eliminated the CTC arguing that the assumptions made in its calculation were obsolete, that it created distortions in the market and that the sank costs of the power plants had been recovered. However, for almost a decade 4.54% of the electric tariff paid by consumers had already been destined to cover the CTC. According to a report by the National Energy Commission quoted by the media (Monforte, 2008), electric companies received 3,396 million euros more than what the electric sector law established for the CTC because mistakes were made in the distribution of the compensations. In the view of the public legal services, the State can

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claim that amount to the electric companies by deducting it from the tariff deficit. As of today the State still has not claimed the 3,396 million euros that would certainly relieve the public debt that has been generated in the Spanish electric sector over the last 14 years. It is also worth mentioning that in the years 2000 and 2001 the electric companies attempted to securitize part of the receivables of the CTC in a similar way as it had been done with the receivables of the nuclear moratorium. This attempt was opposed by the Head of the Spanish Central Bank who calculated that the CTC should have been of no more than 3,000 million euros. Besides, he argued that if the electric companies exchanged the receivables for cash the Government would be unable to determine annually the percentage of the revenues of the electric tariff destined to cover the CTC. Even though the Government initially ignored these critiques, the opposition of the European Commission prevented the securitization of the CTC. The concerns of the European Commission were that such measure would imply an inappropriate support from the State to the private electric companies and a distortion of the competition with new agents (Lopez Martinez, 2013: 117).

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Section 3: The tariff deficit

3.1 Definition and evolution Public debt is created in the Spanish electric sector when the revenues from the electric tariff paid by consumers are smaller than the total costs of the electric system. This is called the tariff deficit. The size of the tariff deficit that is generated every year is very much determined by the Government, which regulates the electric tariff. The electric tariff in Spain has two parts. An unregulated part, which is around 44% of the

electric tariff and represents mainly the costs of acquiring energy from generation companies in electricity wholesale markets, and a regulated part (56%), which collects miscellaneous costs of the electric system, such as transport, distribution, subsidies for electricity in the Spanish islands and the tariff deficit. The Government regulates the electric tariff based on based on forecasts of costs and expected demand. Such a policy has an important element of uncertainty attached to it because there may well be serious mismatches between the predicted and the actual variables. When the Government makes wrong forecasts of the costs of the electricity system, and fails to fix a price that covers the total costs of the electric system, the tariff deficit appears. The tariff deficit of the electric market system is temporarily financed by the five largest generation companies. The amount becomes a debt of the whole of the electric system with these firms. As the electric system finances with the electric tariff paid by consumers, the debt is paid with a percentage of the revenues from their electric tariff. In this way, the cumulative tariff deficit builds up as a claim of electricity companies on a percentage of the electric tariff of the consumers. There is a concept in the electric tariff called tariff deficit which amounts 10% of the bill and is used exclusively to pay for the debt and its interests. The debt of the tariff deficit has grown steadily from 2000 to 2013:

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Tariﬀ deﬁcit 2000-‐2013 (Million €) 7000

6287

5000

4616

4089

4098

3850

4000 2946

3000 2000 1000

5609

5554

6000

1757

1297 250 279

182

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Accumulated tariﬀ deﬁcit 2000-‐2013 (Million €) 45000

40884

40000

36786

35000

31177 27327

30000 25000

21773 17157

20000 15000 10000 5000

6167 250 529

9113

10870

1826 1896 2078

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

In order to prevent the indebtedness of the electric firms when financing the tariff deficit, the companies were allowed to securitize the receivables of the tariff deficit and sell it to third parties as bond-like instruments that are guaranteed by the government. Consequently, from 2000 to 2006 electric companies sold the claims on future household’s payments directly to financial institutions doing securitization. This

practice was already familiar to the electric companies from the treatment of the nuclear moratorium that was explained in the former chapter. With the securitization the firms improve their balance sheet structure. The disadvantage of this is that the Government loses the ability to negotiate the percentage of the electric tariff that is used to pay the tariff deficit. Electric companies were willing to negotiate a haircut of the debt but the financial institutions that acquired the bonds are not willing to negotiate. If they get a haircut then some of these financial institutions may become insolvent.

3.2 A guarantee from the State As the tariff deficit grew over the years it became increasingly harder for electric companies to sell the securitized products in the financial markets. To that the end in 2007 the Natonal Energy Commission managed the bond issuance in three occasions. But the global financial crisis and the lack of trust in the product made the bond issuances fail (Rosa, 2013: 15). That is why Spain’s Tariff Deficit Amortization Fund was created. Fondo de Amortizacion del Deficit Electrico (FADE) was created with the objective of guaranteeing that all the public debt originated in the electric sector will be paid, building confidence on investors and ensuring that bond issues are a success. The company that manages the FADE fund is Titulización de Activos (TdA), the same interministerial commission presided by the Secretary of State of Energy that manages the fund of the nuclear moratorium. The State can use up to 26,000 million euros from the public budget to meet the payments of the bonds issued by FADE (FADE, 2013: 10). Besides, the Official

Institute of Credit created a credit line of 2,000 million euros for FADE. All of FADE’s bonds have an explicit guarantee from the public budget of the State. FADE pays its obligations with the stream of payments that comes from the claims on future consumers’ demand of electricity. FADE issues bonds that are sold in financial markets. The bonds issued by FADE have an interest rate that is also financed with the claims on the consumer’s electric tariff. In 2013 FADE had issued bonds for 18,652 million euros in less than two years. There still are some 5,500 million euros in tariff deficit receivables that may be acquired by the fund from electricity companies (Rosa, 2013: 22). The following graphs describe the mechanics of the relationships of the different economic agents involved in the tariff deficit process through the visualization of their fundamental income and expenditure balances:

3.3 A subsidy The tariff deficit is on the income and expenditure side of the electric companiesâ&#x20AC;&#x2122; accounts. It is compensation for not receiving the total costs of producing electricity recognized in the electric tariff. Electric companies are financing the tariff deficit at a cost that affects its profit margin:

Total Revenue of electricity companies = quantity of electricity sold (tariff price per unit unitary margin + tariff deficit price per unit unitary margin)

What the tariff deficit is doing is a balance sheet effect of the total revenues of the electric companies. The tariff deficit does not appear to be a subsidy thanks to a manipulation of the balance sheet of the Government sector. The tariff deficit is moved off the balance sheet of the Government sector using a non-conventional tax-collection mechanism that finances the subsidy with a percentage of the electric tariff of the consumers. But that percentage is in effect a tax that is charged on electricity consumers to finance the subsidy of the Government to the electricity companies. If the tariff deficit would count as a tax, then the tariff deficit would appear to be a subsidy from the Government sector to the electricity companies. This is in effect a manipulation of the balance sheet structure of the Government sector to pretend that its public debt and its liabilities are smaller than what they actually are. The balance sheets of electricity companies expand every time the tariff deficit is paid to them and shrink when the payment is collected from consumers. The profitability of the electricity companies has been ensured in this way. As a matter of fact, electric companies have maintained their profitability during the worst years of the economic crisis, even despite falling demand. The Spanish electricity companies

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Iberdrola and Endesa had the second and the third largest profits of the European electricity companies in 2012, only after the French giant Electricité De France (Unesa 2013). The costs of the subsidy are recouped with bonds. The payment of the bonds goes to FADE, a governmental entity that issued bonds and acquired loans to pay the tariff deficit (a subsidy) to the electricity companies. In effect, the tariff deficit mechanism is simply an elaborate way of ensuring the profitability of electricity companies. It is a manipulation of the balance sheets of the electricity companies, which in effect are receiving a subsidy from the Government. The effect of the public subsidy on the economic behavior of the recipient companies may be a topic of further research on theories of the firm. Electricity is a good with an inelastic demand. In this sense, we can understand the practice of charging consumers for the tariff deficit in their electric tariffs as an unconventional tax-collection tool. The subsidy is being fed into the companies as a flow and its counterpart is the growing indebtedness of the Government sector. With the use of a special tax collection mechanism in the electric tariff the Government is pretending that it is a debt of the household sector when in effect it is a public debt of the Government sector. The Government is transferring the subsidies to the electric companies off balance sheet because this securitized bonds are in fact Government liabilities, except that they are paid by a ‘tax’ that is included in the electricity bill. One of the implications of recognizing the tariff deficit as a debt of the Government sector is that the official indebtedness levels of Spain would increase. Spain had an officially recognized public debt of 1,046,000 million euros in 2015, 98% of the country’s GDP. Recognizing the tariff deficit as a debt of the Government sector would increase the official public debt of the country by 2.86%, to 1,076,000 million euros.

This would have effects on the official indebtedness levels of the country, what could in turn affect debt reduction negotiations and increase the risk premium of Spanish sovereign bonds.

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Section 4: Factors influencing the tariff deficit

4.1 Falling demand The global financial crisis hit Spain hard. As a consequence, the industrial sector reduced its production and households moderated their consumption, due to their falling income and rising unemployment. These factors affected negatively the demand of electricity, which shrank in Spain for some of the last years. If we consider that many of the costs financed with the electric tariff are fixed (transport, distribution, deficit interests, capacity payments), we realize that their unitary costs for the electric system increases as the demand of electricity falls. This forces the Government to increase prices to cover costs or otherwise incur into tariff deficit. The fall of demand is one of the most significant factors for the creation of tariff deficit. If the electricity demand in 2013 had been 300 TWh, as forecasted in the governmental plans before the economic crisis of 2008, the tariff deficit would not be a problem even at current prices (Lopez Martinez, 2013: 124). The following graph shows the interannual growth (in percentages) of electricity demand from 2003 to 2013. Electricity demand shrank in 2009, 2011, 2012 and 2013:

This evolution has been very different than the one forecasted by the Government in the “Planification of the gas and electricity sectors 2008-2016”. As many others, their expectations did not take into account the effects of the global financial crisis in 2008, which resulted in the electricity demand shrinking instead of growing. More precisely, the expectations of the Government forecasted that the electricity demand would grow in the following way until 2016:

Forecasted demand growth 5,00%

4,50%

4,00%

3,80%

3,10%

2008-‐2011

2011-‐2016

3,00% 2,00% 1,00% 0,00% 2000-‐2006

2006-‐2008

4.2 Overinvestment There is excess installed capacity in the Spanish electricity sector. The installed capacity of the sector is 106,000 MW when the maximum electricity demand has never been bigger than 40,0000 MW. Therefore, there is an installed capacity which is more

than double of the maximum demand. The excess capacity is calculated towards 20% of the maximum capacity. There would still be enough installed capacity to meet the new demand growth of the next eight years even if there were no new investments made in generation capacity from now onwards. From 2005 to 2011, electric companies invested heavily in generation capacity, increasing the installed capacity by 35.7%, while demand only grew 3.4% (Plasencia, 2014: 17). Most of the investment has been made in the construction of combined cycle power plants, which work with natural gas. In a ten years period, electric companies invested more than 13,000 million euros in the installation of 27,000 MW. The huge investments were based on forecasts of demand that expected electricity consumption to be higher than GDP growth. However, with the beginning of the economic crisis electricity consumption remained moderate and even plunged for some years.

Installed capacity of combined cycles 30000 25000 20000 15000

10000 5000 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

As a result, the combined cycles facilities were working at 10.3% of their capacity in 2014, according to data of Sedigas (2014). One of the problems that stems from this situation is that these plants get paid by the electric system for guaranteeing

that they will be available if they are needed. They are part of the fixed costs of the electric system that are financed with claims on a percentage of the electric tariff paid by the household sector. Payments for capacity to combined cycles power plants amount around 900 million euros a year. They are one of the reasons why the gap between the revenues and the costs of the electricity system has widened.

4.3 Market structure and oligopoly The financial restructuring that came after the crisis of overinvestment in nuclear energy (explained in the Nuclear moratorium section) came with a wave of privatizations and mergers and acquisitions, increasing the market concentration and resulting in a close to oligopolistic market. During the late 20th century, Endesa, Iberdrola, Hidrocantabríco, Unión Fenosa, Enagas and the only transmission agent of the Spanish electricity system REE were totally or partially privatized. This placed the problems of owner-management separation on the first order of the political agenda (Trillas, 2002). The following graph shows the mergers and acquisitions activity in the Spanish electric sector from 1983 onwards (Blázquez Gómez, 2008: 97):

After all these movements the Spanish electric sector broke through the 2,000 points level in the Herfindahl-Hirschmann Index1, indicating a high level of market concentration (Blázquez Gómez 2008: 101). In 2004 the generation of energy was concentrated in the hands of two companies: Endesa (42%) and Iberdrola (27.4) (Blazquez Gomez, 2008: 97). Many economists have argued that the Spanish electric sector is in fact an oligopoly. An oligopoly is characterized by few companies in the supply side and an interdependence of the actions of each company, which have the power to influence prices. In the Spanish electric sector firms may have incentives to influence prices in both directions. Firms may want to increase prices to gain additional profits or they may want to push them down to expel their competitors. The production costs of electricity are not publicly available information and electricity companies have systematically refused to carry out audits of their costs. In 2011, the energy regulator punished the five largest generation companies and their union with a 61.2 million euros fine for fixing the electricity prices of industrial consumers (Monforte, 2011). Even though the fine was eventually cancelled by the Spanish National Court, it was penny change for the firms anyway if we consider that only in 2014 the three largest generation companies earned more than 7,000 million euros. The fine represented only less than a 0.87% of the annual earnings of the three largest firms. The electric sector combines segments that are prone to be competitive, such as generation and marketing, with segments that are a natural monopoly, such as transport and distribution. One of the characteristics of the Spanish electric market is that it is 1 The Herfindahl-Hirschmann Index (HHI) is a measure of a firm’s size in relation to

dominated by four holdings that have companies in three of the four segments of the electric industry: distribution, generation and marketing2. In other words, the four leading Spanish electric companies are vertically integrated. Endesa and Iberdrola are the two largest groups of the sector, followed by Gas Natural Unión Fenosa and Hidrocantábrico. The following graph shows how the generation and marketing companies belong to the same holding group (Plasencia Gómez, 2014:10):

This means that the marketing company Endesa Energia buys electricity from a company that actually belongs to the same holding group. These companies belong to the same shareholders, but regulation has forced them to create separate legal identities in each of the segments to avoid cross-subsidization.

2 The transport network is operated exclusively by Red Eléctrica Española (REE), a privatised company that has the State as a small shareholder (aorund 5% of the shares).

4.4 Price formation process The Spanish electricity wholesale market is formed by many different markets where economic agents (electricity generation companies, distributors, marketers and qualified consumers) buy and sell electricity. There are two markets that are of interest for our analysis because the way in which prices are formed in both of them increases the tariff deficit. These are the daily and the CESUR bids. 4.4.1 Daily bids The daily bid is a marginalist market. Marginalist markets are characterized by the fact that generation companies offer energy in bids at prices that are close to their marginal production costs and their variable costs. Nuclear and renewable electricity have close to zero variable costs and that is why their offer to the market is made at a price of zero. On the other hand, electricity generated with coal or gas have higher commodity costs, making their offer to the bid greater than the offers of nuclear or renewable energy. As in any bid, the first offers accepted are the cheapest ones, and that is why renewable energies are the first that make offers to the market. At the end of the bid, when the market has cleared, the prices of the electricity generated with different sources (and, therefore, different costs) are equalized through a market mechanism which fixes the price of the electricity from all sources (and all costs) equal to the price of the last offer made to the market. The price of electricity becomes in this way detached from its production costs and the profit margin of the different companies may differ widely. Attaching the price of the electricity to its real production costs would imply a reduction of the final price of electricity and therefore of the costs of the electric system, what would reduce in turn the tariff deficit.

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4.4.2 The speculative use of derivatives in the CESUR bids The speculative use of derivatives in the bidding process of the Tarifa de Último Recurso3 has inflated electricity prices, increasing in turn the costs and the debt of the electric system. The Tarifa de Último Recurso (Fabra and Fabra, 2012: 93) affects more than 22 million consumers and is used as a reference for the price paid by small, medium and big companies. The Tarifa de Último Recurso is formed through the CESUR bid, a wholesale electricity market bid where the use of derivatives has inflated the final prices for consumers more than 10%. Financial institutions offer future contracts that are used to cover against price fluctuations in the volatile electricity market. The future prices of electricity fixed in the speculative futures contracts used in the CESUR bids have systematically been inflationist. That is, they have systematically set prices which are above the spot price. More specifically, the use of derivatives in the CESUR bids has been done in three-months periods, of which 16 have been with net profits for the financial intermediaries that used derivatives for speculation in the electric market (Méndez 2013). On average the difference between the price they bought energy and the price paid by consumers was 17%. Among the financial intermediaries are found names such as Morgan Stanley, Goldman Sachs, Royal Bank of Scotland and Deutsche Bank. Furthermore, for years the State has paid a premium risk to the economic agents operating in the CESUR bids for the risk associated with the long term maturity date of the transactions. Electric companies that are vertically integrated have a triple incentive for the CESUR bids to be as high as posible (Fabra and Fabra, 2012: 94). First, the offers of the 3 It is the electric tariff that the State arranges por people with lower incomes.

marketers are usually referenced to discounts on the Tarifa de Último Recurso. This means that the higher the CESUR price the higher the profit margin of the marketers. Second, the higher the CESUR prices the higher the profit margin of the net sales of the integrated group in other markets. And last but not least, the generation companies and the electricity traders assume risks when selling part of their energy in the future. Vertically integrated companies have the power of influencing the CESUR bids by retiring from the bidding process. The identity of the companies that participate in the CESUR bids is unknown and there is opacity about them. As already mentioned, the additional problem is that the CESUR bids are used as a reference by the marketers and affects more users in indirect ways. 4.5 Conflicts of interest The ownership structure of the Spanish electric firms creates a web of interlocking interests between the Government, banks and electric companies, that may lead to potential conflicts of interest. The ownership structure of Spain’s privatised firms in the Ibex-35 index is different to the one of non-privatised firms. Their level of free-cash flow is higher (68.91% compared to 56.49%). According to Cabeza and Gómez (2007: 8), the largest shareholders in Spanish electric companies are nonfinancial companies, followed by Banks and savings Banks (each group has more than 9.5% of the firms’ shares) and then by mutual and pension funds (7.43%). The following graph shows the increasing influence among shareholders of savings Banks and construction companies in the leading Spanish electric companies between 1996 and 2006 (Trillas 2002: 527).

The ownership structure of the Spanish privatised electric companies is a consequence of the Government’s strategy of creating a group of stable shareholders after the privatisation process, keeping the control in Spanish hands (Cabeza and Gómez, 2007: 8).

Banks and savings banks participated actively in this process,

creating a web of common interests between electric companies, financial institutions and the State. This web of common interests may distort entry and competition

(Arocena, 2003). 4.6 The electric connections of the Spanish politicians, lobbying pressures and revolving door One of the reasons for the existence of such a regulatory framework, or at least for the lack of enthusiastic market reform, is the web of common interests between a range of institutions that have the capability of influencing energy policy in Spain. The lobbying power of the energy sector in Spain and in Brussels is only comparable to the one of financial institutions and telecommunications. The electric sector has four main fronts which uses to exhort lobbyist pressure. One of them is the influence that they have on the media with threats to remove advertising if they are not content with the editorial guidelines. For example, UNESA, the union of Spanish electric companies, sent a private letter to the President of the TV news channel Antena 3 after they broadcasted a report on the tariff deficit. Besides, electric companies have strong connections with powerful law firms that support their interests fiercely. The strategy of the electricity companies is to systematically appeal any law related to the energy sector to make it more convenient to their interests. Last but not least, the phenomenon of the revolving door is a widely used lobbyist technique used by electric companies to influence in the design and strategy of energy policy. It basically consists of hiring formers politicians as consultants or employees of the electric companies so they can represent their interests in front of their former colleagues. The presence of former Spanish politicians in private companies is commonly accepted by law and society despite it may result in serious conflicts of interest. In 2010, 48 of the 487 board members of the Ibex 35 companies â&#x20AC;&#x201C; the 35 most traded

36 Â

companies in the Spanish stock exchange- were occupied by people who either work or have worked in public charges (Vélez, 2010). Authors found that the phenomenon of the revolving door may be an explanation when the interests of the companies are held above the interests of society. Villoria (2014) emphasized that the phenomenon of the revolving door occurs more frequently in the energy sector because it is dominated by powerful companies that are heavily dependant on public regulation. Some of the most interesting examples include the one of José María Aznar, who was hired by Endesa, a company that was privatised while he was President of Spain. Similarly, Felipe González went to work for Gas Natural. Gas Natural acquired the Enagas, a public company that was privatised while González was President. Furthermore, Pedro Solbes was hired by the Italian company Enel. Solbes was Minister of Economy when Enel acquired Endesa after a long battle with the German company E.ON. The following list shows some of the Spanish politicians that have gone to work on private electric companies after their mandate ended (Cuesta, 2013; Grasso and Escudero, 2013; Suárez, 2014):

4.7 The ambivalent impact of renewable energy It is often argued that public debt was created in the Spanish electric sector for subsidizing renewable energies. It is true that for many years a percentage of the electric tariff was used to subsidize the renewable energy industry in Spain. Even though the subsidies to renewable energy increased the tariff deficit, the increasing use of renewables in the energy mix had a price reduction effect on electricity (APPA 2013).

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Renewable energies are sold in wholesale markets at a market price of zero in order to prioritise the use of renewable energy in the system. The price of renewable energy is determined by the Government which pays the generation companies for their renewable energy through a special regime with a percentage of the revenues of the electric tariff. Renewable energy can be paid through a special regime because its variable costs are close to zero. This policy displaces therefore the traditional and more expensive generation sources, dropping the overall price of electricity in the wholesale markets because part of the electricity has in effect been sold at a zero price in the bid. While the premiums to the renewable energies have costed 6,136 million euros, they have generated savings for 6,576 million euros in the bids with their price reducing effect (APPA 2013).

§

Section 5: Consequences

5.1 Impact on the renewable energy sector The rise to power of the conservative Partido Popular came with the elimination of a big part of the subsidies for renewable energy. The political move was a hit to the development of an emerging real economy that was included within a set of reforms aimed at reducing the tariff deficit. The measures of the Government reduced the incentives to invest in renewable energies, making the country drop in the Renewable Energy Country Attractiveness Index (EY 2015). Until 2011, the Government had largely supported the renewable energy sector with subsidies that were collected from a percentage of the electric tariff. The renewable energy sector grew in Spain and the country became a leader in the industry. Spain’s exceptional climate conditions for the production of solar and wind electric power implied that the country had a qualitative advantage in the field.

Despite several cuts on the budget Spain still remains a great generator and recipient of subsidies for renewable energy, ranking in the fourth position in the world with 6,400 million euros in subsidies in 2013. The new energy policy of the Government penalized with taxes the production of renewable energy, but renewable energy production remains economically viable. The Government has also forbidden small producers to inject energy into the electric power system and recover it later when needed, or to sell it. Furthermore, the electricity companies that control the infrastructure to inject electricity into the system are competitors of the renewable energies in the generation segment. Greenpeace (2014) has claimed that these companies are creating obstacles for renewable energy companies to access the system to inject energy. Renewable energies constitute an opportunity for Spain to socialize the production of electricity if the country creates a network of small auto-consumerproducers of renewable energy. Such a measure would have the advantage of dodging the typical barrier of entry of the electricity market with the low investment costs associated to the installation of small-scale renewable energy capacity. Increasing the presence of renewable energy in the Spanish energy mix would also have positive effects in its balance of payments (López Martínez, 2013: 125). Besides, the use of renewable energy avoids carbon gas emissions, which are also costly for the Government sector in terms of carbon gas emissions rights and fines. An additional advantage of renewable energies is that it creates more jobs in the labor market than the traditional sources of energy (Sustainlabor 2012). Therefore, continued investment in the renewables sector could ease some of Spain’s structural problems, such as the energy deficit and unemployment.

5.2 Public finances The tariff deficit has a negative effect on Spain’s public finances because: (i) Up to 26,000 million euros of the public budget of the State can be used to meet FADE bonds’ payment obligations; (ii) a 2,000 million euros public credit line has been created for FADE to meet its payment obligations; (iii) the subsidies to the electric system costs of the Spanish islands, which were before financed with a percentage of the electric tariff, have later been allocated to the expenditure of the public budget. The subsidies for the prices of electricity in the Spanish islands amount around 1,800 million euros a year.

5.3 Distribution effects and energy poverty One of the direct consequences of the increase in electricity prices that was done to pay for the tariff deficit has been the growth of energy poverty. The combination between low energy efficiency, falling income, rising unemployment and electricity prices rising has pushed over 7 million Spaniards into energy poverty. Even upper income families have moderated their electricity consumption due to the higher prices. Since the economic crisis started in 2008 the cut-offs rocketed and in 2013 only between Iberdrola and Endesa they cut-off the electricity to one million people. Furthermore, according to a report by the World Health Organization, energy poverty is the cause of 7,000 deaths a year in Spain. If the problem of the tariff deficit is solved by increasing electricity prices while income remains falling or stagnant, this will increase energy poverty and reduce even more the demand for energy, increasing in turn the initial debt.

§

Section 6: Conclusion

This paper has shown that the tariff deficit is in effect a subsidy from the Government sector to the electricity companies. The Government sector manipulates its balance sheet when it finances the subsidy with an unconventional tax-collection tool which uses around 10% of the electric tariff paid by consumers to pay for the tariff deficit. The case study can be valuable for further research on balance sheet manipulation of the State and hidden subsidies. It is the first time that a paper considers the tariff deficit to be a subsidy. Besides, this paper has for the first time explicitly dealt with the tariff deficit as a phenomenon of public debt. There are severe implications to reaching these two conclusions. If the tariff deficit is in effect a subsidy from the State that has created a debt that is public, then Spain’s official public debt would increase 2.86%. This, in turn, could affect debt reduction negotiations and public debt reduction objectives. At the same time, it can deteriorate the credit score of the country, what would in turn increase its financing costs and augment its public debt. Furthermore, this paper has analyzed a number of factors that have aggravated the tariff deficit. More specifically, the tariff deficit has been aggravated by a crisis of overinvestment that led to overcapacity in the system, in combination with falling demand and an oligopolistic market structure. Besides, the financial intermediation of the public debt has increased the initial debt. Another striking feature of the analysis of the electricity sector is the creation of a vast net of interlocking interests where former politicians go to work as lobbyists for private electricity companies, leading to potential conflicts of interest.

Appendix: Country energy profile Spain is a net importer of energy with an energy dependence index of 70.5 in 2013, according to Eurostat4. The Spanish economy is one of the most energy dependent of the EU. The Spanish energy deficit reached to 38,071 million euros in 2014, 20,9% of the country´s imports. This negatively affects the country’s balance of payments and, consequently, its public finances. As a matter of fact, the country would have a positive trade balance if it weren´t for energy imports (Martínez, 2015). Spain’s installed capacity is distributed in the following way (REE 2014: 11), according to the energy generation mix:

Installed power capacity Combined cycle

1,0% 4,3% 2,2%

Coal Nuclear

24,8%

22,3%

Fuel/gas 10,7%

19,5%

7,0%

7,7%

CogeneraDon and others Hydraulic Eolic

0,5%

Solar photovoltaic Solar thermal Renewable thermal

Prices have been rising year after year in Spain but this has not been sufficient to cover the total costs of the electricity system. In the second half of 2014 Spanish consumers 4 Energy dependency shows the extent to which an economy relies upon imports in order to meet its energy needs. The indicator is calculated as net imports divided by the sum of gross inland energy consumption plus bunkers.

paid the fourth most expensive electricity prices of the European Union (Eurostat, 2015).

Electricity prices for domesFc consumers including all taxes and levies (€/KWh) 0,2500 0,2000 0,1500 0,1000 0,0500 0,0000

Spain European Union (27 countries)

Electricity prices for industrial consumers including taxes (€/KWh) 0,2000 0,1500 0,1000

European Union (27 countries)

0,0500

Spain

0,0000

The phenomenon of electricity prices increasing as demand falls shows that someting abnormal is occurring in the market. The electric sector is heavily regulated and therefore may not always obbey to the fundamental laws of supply and demand.

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