Five ways to destroy your energy sector and your economy – a note to the Hungarian Government

I was aiming low – ‘Five ways to destroy your energy sector and your economy – a note to the Hungarian Government.’ I IM’d the title to my friend in the Hungarian energy sector – he said, “i am sure they know at least ten.” Well, most certainly they do, but I’m not as creative as the current Hungarian government. How could I even imagine that encouraging consumers to not pay their energy bills would become a government policy – and legalized. Nonetheless, I’ve written about creative tax making in the past.

To herald in the New Year and to recognize that the wise men (and women) from the EU and IMF may be gone for a few more months and as the Orban government continues to force the country into a downward economic spiral, and installing a new authoritarianism, I thought I would provide the current government a Christmas package of proposals that could bring the Hungarian energy sector more quickly to its knees. Because, as I will show, once you have destroyed your energy sector, dissuaded manufacturers from investing due to an unstable electricity sector, the only direction to go is up – and this requires foreign investment, an effective regulatory environment and strong political will that corrects the past mistakes of low/subsidized energy prices (as demonstrated in this study).

One: Encourage consumers not to pay their energy bills

The introduction of a new bill in the Hungarian Parliament would allow public institutions like schools to avoid pay their utility bills. This proposal has caused the National Development Ministry State Secretary for Climate and Energy Affairs Janos Bencsik to submit his resignation.

A proposal submitted to Parliament by Fidesz parliamentary caucus leader János Lázár last week seeks to prevent utility companies from shutting off power to certain customers who fail to pay their bills…. Industry insiders said that the proposal would allow public institutions, many of them notorious late-payers, to ignore their utility bills with no consequences, leaving power companies no recourse but lengthy and costly legal suits.

Macedonia, provides a good example as to what can happen when no penalities are imposed on late or non-payment of electricity bills. Essentially, the Hungarian proposal reverts back to the Socialist era, when non-payment was rampant in some countries.

Hungary's new energy slogan

 

In a study on the privatization process of the Macedonian electricity company (with the distribution entity being sold to EVN) I wrote, “Unpaid consumer bills, mainly from the period before privatization, are a significant issue. EVN is pursuing lawsuits against 400,000 customers for non-payment, 80% to 90% of these cases stem from the pre-privatization period. This is down from a high of 450,000.”  The draft report was read by reviewers and they came back to say that this 400,000 number must be an error. ‘Didn’t I mean 4,000?’ No – 400,000 court cases for non-payment.

The huge number of non-payment from consumers were causing significant losses to the company at the time of privatization, around 30% of the electricity transmitted in 2006 was unpaid. Of course, these losses affected the selling price at the time of privatization, as well as an indirect impact on investments and the price of electricity – and certainly a very acrimonious relationship between the government, regulatory and EVN. At the end of the day, it is the rate payer and tax payer (usually the same) who has to pay for this.

Lesson 1: to devalue a company, lower investment and create system instability encourage consumers to NOT pay their energy bills. If the company is already foreign owned, this method will be sure to create losses for the company and may encourage their withdrawal.

Two: Regulate the price of energy below the cost of providers

The case of Bulgaria’s privatization of its power plant in Varna, to the Czech power company CEZ,  demonstrates that it doesn’t have to be just the distribution companies that can be forced to eat the losses. In the same study, the decision by the Bulgarian regulator to decide on the price of electricity that would be allowed for power production from the privately owned power plant demonstrate that  it is also the generators that sell to the distribution companies in the regulated market, that must contend with the low prices.

“In the case of CEZ’s Varna Power plant the complaint centers on two issues – regulated segment market quota and the price on the regulated segment, which, according to CEZ, is set lower than production costs. CEZ Varna states that it needs over Lev 77/MWh, to be at cost, while the approved rate from SEWRC is under Lev 72/MWh.”

The development of energy regulators is something special, however, the Hungarian government views the current regulator as not knowing better than Parliament. Since June 2010, the Hungarian Energy Office lost the power to effectively and professionally regulate the price of electricity and gas.  The justification: “it is intolerable that a significant part of families’ budgets consist of utility bills.” Therefore, the regulator is the wrong unit to ensure that families can pay their bills.

The recent ‘forced’ sale of E.ON’s gas unit to the Hungarian government, and the dumping of E.ON Bulgaria by the mother company, both demonstrate what squeezing by governments does. It is still not clear how consumers benefit from government political decision making or ownership. In the case of Bulgaria, one of the main reasons, that I was able to extract from a key participant in the privatization of the distribution companies, was the fact that the government could not be trusted to ensure investments were done due to the desire to keep prices low. The same case certainly applies to Hungary – in the medium and long term, the energy sector will begin to fail if investment levels are not maintained or even increased. It takes reflective pricing of the actual costs of the energy system to ensure proper levels of investments are done to maintain and improve security of supply.

Lesson 2: to ensure that the energy system does not improve, or begins to deteriorate, make sure that companies do not have sufficient funds to cover operating and capital expenses (CAPEX and OPEX). Either removing the regulator from the decision making process or placing political pressure on the regulator can result in lower energy prices. The result can be the company is sold back to the government at a low cost. Great strategy if forced nationalization is the objective.

Three: Create a regional hegemonic energy company!

There is nothing like nationalism to fuel erratic policy making. Ideology both pro or anti-market can dent and over simplify the complex relationship between the state and private investors in the energy sector. The fact that the energy sector is a fundamental component to economic growth and a direct link to voters (through their utility bills), makes the energy sector a highly politicized (read why politicians find energy as attractive as prostitutes). It would require a book to write about all the different and constantly changing national energy strategies in Central Eastern Europe and the South East of Europe to review how almost EVERY country considers their state owned energy companies strong enough to become a regional player like CEZ. The present result is that these ambitions have only resulted in continued justification for government ownership and a lack of modernization of assets for domestic users. Hungary, Bulgaria and Romania each has these strategies, yet none of them competes regionally.

For Hungary, the government sees that MVM (the state owned former electricity behemoth that is now being used to control everything from gas to telecoms) can fulfill this regional ‘cash cow’ role. Or as Janos Lazar, head of the parliamentary group of the Fidesz party, said in an interview. “I see great potential in MVM, in building it up, on the national and regional level. There’s a lot of money to be made here, a lot of money,” said in a Bloomberg interview. (see previous post on this.)

Hungary's future 'regional' cash cow - maybe a little too fat to make it out of the country

Lesson 3: To help justify why the government is so important in a country’s energy sector, just keep saying that they will be expanding regionally – and there is a lot of money to be made. This expansion still has not occurred, and if it were to occur it must be subsidized by current rate/tax payers. Nonetheless, there is still room for a first mover advantage by one of the large state owned energy companies – like MVM (see photo above to see how fast they can move).

Four: Create an erratic policy and regulatory environment

Maybe this goes without saying. Having an erratic policy and regulatory environment is usually built into the business plans of privately owned energy companies. For rate payers, this means paying more for their energy, because the risks are much greater and therefore energy companies entering and operating in a company are going to seek to have a higher rate of return. The rate of return that the electricity distribution companies received at the time of privatization in Bulgaria was 16% and 12% in Romania. While this may be great for the investors – at least on paper – as the case studies show, the risk that these companies took is partly justified based on the continued price squeeze that the companies are under. They are expected to fulfill their investment commitments, thus incurring losses, thus lowering the rate of return (in a very simple explanation). Whereas, a more predictable and stable regulatory environment can, over a few regulatory cycles can lower the rate of return, the country’s risk level and thus energy prices.

Lesson 4: erratic energy policies and regulations, can keep risk levels high and thus require companies to have a higher rate of return. This will result in higher energy prices, so instead of creating a stable predictable investment environment, keep companies guessing – this will justify the continued political intervention in the energy sector.

Five: Get free energy for government use – expropriate electricity and gas

Hungarian Prime Minister, Viktor Orban speaking in December 2020, at a primary school about the success of the free energy scheme for state institutions

 

Political control over energy prices, means that privately owned companies must accept what the government tells them to charge. The point of having an energy sector regulator is to ensure that there is sufficient incentive for privately owned companies to get a fair rate of return on their investments, while protecting consumers from monopolistic abuses. A professional regulatory staff  assesses the full costs that are incurred by privately owned companies, and ensure the costs are justified and consumers pay for an efficiently run energy system. Removing incentives or not covering the cost of operations and future investments, removes the incentives to invest and threatens security of supply.

The Hungarian government now controls the price of gas and electricity. They are also about to decide that certain consumers (state owned entities) do not have to pay their energy bills. If they allow this, the government in reviewing the costs that should be allowed in the price caps, can decided that the non-payment by these consumers cannot be viewed as losses for the company to write off – or for other consumers to cover. They will force the private electricity and gas providers to pay for the energy costs of the government.

In short, as in the Socialist era, the Hungarian government will decide that government institutions do not need to pay their energy bills, they will either make the Hungarian rate/tax payer pick up the tab through their utility bills – thus higher prices, or they will force the companies to incur losses caused by non-payment from the government.

Lesson 5: If you want to ensure that the government (through whatever entity local or national) does not pay for energy usage, simply make sure the price is set by the government and stipulate in law that there are no penalties for non-payment by government entities. This will dissuade energy efficiency improvements and drive the price of energy up for everyone else – if these losses are included in the price of electricity or gas.

 

Conclusion

The five points reviewed here represent the ways that can lead to decreased investment, less private ownership(which should be more efficient), and higher energy prices for all. The one area that I have not touched on is how creating a stable investment environment, with a well functioning and independent regulator also can create lower energy prices. Erratic policy making, expropriation of energy by the government and increased state ownership all lead to higher energy prices for consumers. In the long term, the trend will only lead to an under invested energy system that has blackouts, lacks system stability and cannot support the requirements of industry. A robust energy system is a requirement for a growing economy. Failure in the energy system represents failing every citizen. The Hungarian government is only too happy to ensure that the private ownership is diminished or eliminated while state owned energy companies with no transparency -(and a history of not justifying their costs, like private utilities), become fatter and fatter. I don’t know if fat cows produce more milk, but they certainly cost more to feed. If the cost of energy is the bottom line, then let’s have some lean beef that is healthier for the consumer.

E.ON gets fed up and disposes of E.ON Bulgaria

In one sense the headline that E.ON chose for its own press release says it all:

E.ON disposes of E.ON Bulgaria

The reason given in the press release is due to the corporate strategy of divesting “15 billion euros in assets by the end of 2013. So far more than 9 billion euros have already been realized.” Couching the disposal of a corporate unit as wrapped up in the shifting corporate strategy is as polite as a corporations gets to admitting that maybe after seven years of this relationship (the seven year itch?) things didn’t work out well. How much things didn’t work out can be seen in the original purchase price and the proposed sale price of the unit to the Czech based Energy Pro. E.ON paid EUR 140 million in 2004 and is now selling it for EUR 133 million!! A EUR 7 million loss after 7 years of continued investment in the company.

View from trash can in Bulgaria

The first notable reason for the difference in buying and selling price can be seen that E.ON overpaid in 2004. During this expansionist period of German, French and Italian utilities there was firm bidding on the different companies throughout the South East of Europe. The expected long-term time horizons, perceived favorable regulatory environments and the economic growth of the countries all led investors to see self sustaining units that could provide profitable revenue streams. However, soon after privatization and the sale of the unit to E.ON by the Bulgarian state, the regulatory and political environment were not as rosy as they first appeared.

My analysis here is based on a 2009 study Vidmantas Jankauskas (former regulatory of Lithuania) and I wrote about in a report funded by USAID and NARUC. This examines the privatization process and the post-privatization issues arising from the sale of the distribution companies in Bulgaria, Macedonia and Romania. The research is based on a series of interviews, mainly in-person, that we conducted in the summer of 2008 with company representatives, regulators and other professionals connected to the privatization process.

The dedication to the privatization process of the essentially bankrupt country of Bulgaria in the post-communist era can be seen in the significant rate increases. In 2002 rates were increased 20%, then 15% in 2003 and finally 10% in 2004. A regulatory agency was established and the tariff methodology was established so all potential investors could see this before bidding. However, after privatization the sand quickly shifted under E.ON’s feet (and other investors, EVN and CEZ).

At the time of writing the report in 2008, the Bulgarian energy regulator and the privately owned distribution companies, seemed to have enough of each other. Loses were now seen being forced on the companies due to the decision by the regulator not to increase electricity rates.

Utility executives view recent action by SEWRC [the regulator] as impacting their ability to conduct and recoup investments. An example of this complaint is the announcement made by SEWRC on July 1, 2008 that electricity rates would increase by an average of 14%. The distribution of the rate increase would go to the largely state owned firm NEK. Because of this the three private firms in Bulgaria are now filing suit in Bulgarian courts and at the European Union level. For E.ON Bulgaria the price increase would yield a 1% increase for the company out of a total price increase of 17% in their distribution region. According to a company official this would mean that “E.ON would not be able to cover its investment commitments toward maintenance and improving the quality of services it offers, while operational costs would decrease by 80 million leva.” Figure 2 (below), presented by E.ON Bulgaria shows the difference between the company’s applied Opex and Capex and those granted by SEWRC on June 26, 2008.

Applied and Granted OPEX andCAPEXCosts for E.ON Bulgaria

Source:  E.ON, “Tariff Decision 2008, 2nd regulatory period.” in, “Power distribution firms to sue utilities regulator over electricity price hikes – Business news.” July 9, 2008.

In the world of boring electric distribution companies, the above case demonstrates the state is ready to force losses, onto the distribution companies, while also cutting the overall service quality that these companies can provide for consumers. This article, describing the terrible service of E.ON Bulgaria and bidding it farewell, may be more representative of the unwillingness of the state owned transmission system operator to invest and the inability of all companies to invest sufficient amounts into the overall Bulgarian electric system. Low prices for consumers may also translate into poor service.

In a telling interview, with a key individual involved in the privatization of the Bulgarian distribution companies, he stated that these fights between the companies and government don’t tell the whole story. Rather the companies were viewed as having made out rather well, and were profitable along with buying the companies at a low value. This perspective has always informed my analysis of the situation in the country. There may be fights, but maybe these investors are better off than they let on. I think the final sale price demonstrates that this is not the case. The actions of the Bulgarian government and even the independent regulator have not served the people of Bulgaria or the investors since privatization. The rate increases before privatization demonstrate the willingness to open up and allow market forces, but the actions of the state since then demonstrate the great distrust of private capital and somehow energy prices should be kept low at all costs – even if this means damaging the service quality, investor expectations and overall economic growth of the country.

The actions in Bulgaria should serve as a warning sign to other investors and governments. It is true that E.ON sold the unit to another private company, thus demonstrating that investors remain interested in the country. However, the long term growth and the operations under such a tight and awkward regulatory environment demonstrates that even after 7 years of investments the value of the company has dropped, service quality has not improved, and South East Europe is no longer the place for large investors. Other countries, like Hungary, Macedonia and even Romania should take note. Investors will not hang on forever to wait for economic and political policies to see profits or at least a stable operating environment to materialize. Private investors seek to modernize the national energy infrastructure, failure here results in wider economic, environmental and societal failures – caused by government actions.

Nabucco, and the distant love of Europe

Nine lives or no lives? That is the prospect for Nabucco.

Noise or game changing events: another round of alternative pipeline plans, the re-positioning of political actors, makes another act in the Nabucco opera either more intriguing or increases the restlessness of the audience.

Separate actions inflict little wounds on Nabucco but collective cuts may be eroding the ground underneath. Does the U.S. still fully support Nabucco? What’s the purpose and/or reality of  the new South East Europe Pipeline project?

Will there be any life for Nabucco?

All these questions lead to separate and diverse perspectives of what the future may hold for Nabucco. The doubts begin to settle in as the relationship between EU backers and the governments in the two distant regions move beyond the courting phase of their relationship and seek to build a solid gas link.

Reassessment of relations

There comes points in a long-term relationship where an assessment of what each partner wants…. is it true love, infatuation or is there a true coupling where each partner brings important elements to the relationship? Europe must decide whether it wants to develop the relationship further with the countries of the Caucases and Central Asia. The recent – warning shot – provided by the U.S. State Department Special Envoy for Eurasian Energy, Richard Morningstar should begin to focus attention in Brussels. The ‘misinterpreted’ comments that smaller pipeline projects that are more commercially viable may be better.  While the U.S. embassy rushed out a ‘clarification’ it still states that the sooner a commercially viable pipeline is built the better.

Reality or love

There are always reasons why a relationship will fail over the long term. Particularly when you put two ‘individuals’ together from two different cultures. Maybe now is the right time to review these. What are the worries that prevent countries from the EU to solidify their relation with potential supplier countries for Nabucco?

Financial:  “How are we going to pay for it?”

Distance: “But you are so far, can we really have a long distance relationship?”

Distractions: “What if you find someone else, while I’m away?”

Parental approval: “My mother wouldn’t approve” (i.e. Mother Russia)

“Your father has other plans for you.” (i.e. US wants EU to use shale gas)

Hometown girl: “Maybe you want a girl from home.” (i.e. shale gas)

Like most love story, it is the parents that get in the way. Those guardians that seek to steer their children in the right direction. Mother Russia certainly has a strong interest to insure that the EU is only supplied by Russia. The United States, is attempting to force a gas strategy on Europe – shale gas. The recent Baker Institute Study that projects a drop in European gas dependency from 27% to 13% because of the full utilization of European shale gas, has unfortunately – I believe, influenced US policy to push the EU to delay or stop the Nabucco Pipeline. Therefore comments emerge that discourage investment into Nabucco and encourage switching to a lower capacity pipeline that is commercially viable in the short term.  Pursing the most commercially viable pipeline option today does not provide the long term boost to security of supply nor provide the foundation the EU needs to have gas fill its power plants.

Multilateral and multicultural relations are at the heart of everything the EU does. Also central to the EU is the role of energy – the foundation of the EU rests on energy. Providing the will and reasoned justification for building a robust pipeline that will serve the long term interests and needs of Europe requires significant commitment today. Many of the issues that are meant to derail Nabucco are not strong enough to trump the security of supply implications that expanded gas supplies, that are not controlled by Russia, offer. Just as love can overcome obstacles, the large and abstract notion of security of supply serves as the impetus to take resolute steps to cement a relationship. It is time to stop worrying about what the future in-laws think.