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When people meet me at a party, it’s usually 50/50. It goes something like this:

Them: “So… what do you do?”

Me: (exhales heavily) “I’m studying Energy Law.”

Them: 👁👄👁

Me: “It’s a combination of law, economics, and policy, focused on the energy sector and electricity grids specifically.”

Here comes the 50/50.

Truth aside, some people have asked me what I’ve learned so far and this essay is my answer. It is a human-readable introduction into the most important concepts of Energy Regulation.

Let’s do this!

Kids are masters of the laddering technique.

They ask a question and follow it up with endless rounds of why? why? why? What consultants charge big bucks for, kids do for their own curiosity. They are natural truth seekers.

To explain Energy Regulation, I’ll go on an imaginary walk with a curious kid 🙋

Short answer: Those are Transmission Lines and they are like a highway for electricity 🛣

Those funny spaghetti things transport electricity from one place to another. There are two types of them:

At the end of the day, this large spaghetti bowl makes it possible that someone generates electricity on the other side of the country and it miraculously arrives at your power outlets in your house 🔌

Short Answer: Our society runs on electricity 💡

Well, you might think “what’s the big deal if I can’t charge my phone for a day?”

Everything around you needs electricity. The street lights, the public transportation system, the devices in the hospital, the flush in your toilet, and even the tap water in your kitchen.

If there’s no electricity for a an hour it’s a major inconvenience 😒

If there’s no electricity for a day it’s a major event 😰

If there’s no electricity for a week… all hell breaks loose 🔥

Because electricity is so important, we refer to the grid as an essential facility.

These essential facilities (i.e. spaghetti things) are usually created and looked after by one large company.

Short Answer: It is cheaper to have only one company looking after the electric spag bowl.

Energy infrastructure - in this case the electricity grid (i.e. spaghetti) - is very expensive to build:

If multiple companies build such infrastructure, it wastes a lot of resources (money; time; space).

Economists call this Productive Inefficiency - a situation where it is bad for everyone, if multiple companies try to compete in the market. Therefore, some markets like telecommunication, railways, and energy markets are considered to be natural monopolies. In such markets, there can only be one company running the show.

As a result, someone needs to define the rules of the game.

Short Answer: Players abuse the game if there are no rules 🦹‍♀️

Think of a game of football - you know the European game you actually play with the foot ⚽️

In its current form, there are two teams of eleven players each. They play for 90 minutes against each other and try to outscore their opponent.

If there were no rules, one team might show up on field with 20 players while the other team might decide to play with their hands all over the pitch. To avoid such a mismatch, there are clear rules.

What works in football also works for electricity markets.

Now, let me tell you a story about the frog 🐸 and the scorpion 🦂

In our case, a natural monopolist is the scorpion. It is in their nature to abuse the game for their economic benefit.

In short: Set rules for the important stuff in advance and judge the rest on the fly.

Short Answer: Alternatives exist but unfortunately they don’t work.

[This is a slightly more technical excursion 🤓]

There are six experiments, which don’t work well in practice:

[End of excursion]

The truth is that regulation is the best idea we could come up so far.

Short Answer: Split the monopoly, force them to give access, and control their prices.

Disclaimer: By now the curious kid has miraculously reached the maturity level of a graduate student, which makes my life easier, since I can talk in professional language. What a peculiar kid 🤷‍♂️

Regulators use policy instruments to achieve their policy objectives. A policy instrument is a law or set of laws, which can change the rules of the game.

In energy regulation, we usually talk about the three main regulatory instruments to protect the energy markets:

You can think of the natural monopolist as someone who used to control all steps of the value chain.

Let’s discuss the example of a food market in a small town:

The critical part is the food market. It is the only place in town where food can be sold and bought. This is the essential facility. Without it, people would starve.

But what happens to the other parts of the value chain outside of the essential facility?

The regulator decides to open those areas up for other companies. The invisible hand works if competition is possible. For this reason, the regulator uses Unbundling to split up formerly vertically-integrated undertakings (VIU) - a fancy term to describe a monopolist who controls all steps of the value chain.

In the spirit of Productive Efficiency, it makes sense that only one company builds, operates and maintains an essential facility (i.e. the spaghetti; the transmission grid).

The regulator grants a special right to the infrastructure provider to remain a monopoly - yet a regulated one - in the transmission area. All other areas are opened up for competition.*

*Disclaimer: This is an over-simplification for the sake of this article. In reality, there are different modes of unbundling. If there’s demand for an analysis, I can discuss this topic in detail in another essay.

In the case of the electricity market this means:

Unbundling is usually the first step in regulating and liberalizing energy markets.

First, we unbundle the vertically-integrated energy monopoly, then, we invite other companies to the table.

Competition is useless if other players can’t place their chips and participate in the game. But there’s a problem. The regulator knows that Exclusionary Conduct (i.e. not letting others use their infrastructure) is in the scorpion’s nature.

Natural monopolies have a special responsibility due to their control of the essential facility. Yet, in reality, they don’t always fulfill their responsibility. Instead, they come up with creative reasons (capacity hoarding; etc.) as to why they can’t grant access to their facility.

Think back to the food market. It is as if the market provider only opens the door for some and keeps it shut for others. This is a clear discrimination of market participants and it is a problem because others depend on the access to the market.

To reduce this risk, the regulator introduces Third-Party Access (TPA). It is a legal requirement for the transmission system operator (TSO) to provide non-discriminatory access to its essential facilities.

This law is what enables competition but the regulator has to strike a fine balance. Without TPA there is no competition, but without regulated TPA standards, an infrastructure provider might be overburdened by the volume of access requests - after all, it takes resources (money, time, etc.) to expand and operate the essential facility.

Now that others can finally use the infrastructure, the natural monopolist is charging them for their usage. That’s fair.

What’s not fair is charging an excessive/monopolist price to other market participants. The regulator is forced to set prices for the regulated monopoly because Exploitative Conduct is in the scorpion’s nature.

Once fair prices are established, the other companies have a chance of participating fairly in the electricity market.

As you can see, energy regulators have the power to shape the rules of the game.

And the good news is that they are actively doing it in many regions of the world, whether it’s the IRA legislation in the US, or the European Green Deal in the EU. The game is changing right before our eyes and new players are welcome.

As I wrote in my previous essay:

I hope this piece has given you a basic understanding of the regulatory unlock that is happening in this market.

…

Now, where were we? My young friend and I arrive at a cross-roads where we say goodbye. But before we part ways, I ask the kid: “What’s that on the Horizon?”

To which the kid replies: “Opportunity.”

If you enjoyed this essay, please consider forwarding it to a friend who wants to get started with climate 🌳

If you have feedback/ideas/critique/etc., please let me know how I can improve.

The subscriber growth since the last essay was wild.

100+ new climate buddies joined because of a silly Linkedin post.

On another note, I’m still working on framing the electricity market as a fantasy/sci-fi short story that’s set in a kingdom full of intrigue and fun creatures.

I’m not quite sure which sub-story I should explore first. Hence, asking y’all what you’d like to read first: