CEZ may flex its monopsonic muscles but for EPH the villain of the piece remains Czech Coal.



Severoceske doly is the elephant in the room

December 20th 2012: Until this week, we were labouring under the impression that CEZ was offering to sell one of four power plants under conditions dictated by the European Commission in an effort to settle a three year investigation into market abuses.

But we were wrong. On the day Czech Coal was due to be pulverised into particles of coal dust, yesterday that is, CEZ’s beleaguered boss Daniel Benes informed the world that he has, and I quote, ‘not the slightest reason’ to sell the most sought after of the four designated plants, the lignite-fired Pocerady in Northern Bohemia.

This is immensely reassuring for EPH, which must be counted the friendliest competitor any national champion could wish for.

Czech Coal has made no secret of the fact that it wants to acquire Pocerady, which is situated conveniently close to its own lignite mines. And EPH (and the Czech district heating association led by EPH’s celebrity spokesman, Mirek Topolanek) has made no secret of the fact that it wants to stop it from doing so. This week, it became clear that CEZ is as determined as EPH to prevent Czech Coal from getting its dirty paws on Pocerady.

Before stepping into the head of EPH, and imagining the arguments it might make to convince the European Commission not to oblige CEZ to divest Pocerady, here are some important and uncontested facts.

The domestic lignite market is an oligopolistic market made up of 3 firms of which by far the biggest supplier is CEZ’s own Severoceske doly, with 25 million tons of lignite in 2011. Then there is Czech Coal with 14 million tons from its Most mines, and finally Sokolovska uhelna, with less than 4 million tons. And just to remind readers, all of the lignite used in CEZ’s Pocerady and EPH’s Opatovice is today supplied by Czech Coal. Together, these two power plants absorb most of Czech Coal’s lignite, half of which goes to Pocerady and a further 2 million tons to Opatovice.

It becomes clear that if Czech Coal were to acquire Pocerady, its biggest customer, then EPH’s bargaining power with Czech Coal over fuel supplies for Opatovice would weaken.

I assume that the argument EPH will be making to justify its objections will be built upon the claim that Czech Coal, not CEZ, is a dominant supplier of lignite. This is false.

The conclusion that Czech Coal dominates the relevant geographic market for lignite (which is the Czech Republic) is possible to reach only if in-house deliveries for own consumption, in other words, deliveries to yourself, are excluded. When these are included, as they should be, CEZ’s Severoceske doly is indisputably dominant.

Generally, in-house deliveries are included in the relevant market after passing a simple test. This test says that, if the price of lignite increases by a certain amount, and as a result, the vertically integrated firm (CEZ in this case) decides to sell its lignite on the market instead of delivering in-house, to itself, then the in-house supplies are considered part of the relevant market.

The test above assumes market conditions which do not apply in the Czech lignite market today. The key assumption is that CEZ’s Severoceske doly would sell its lignite on the market if the price were to increase by such and such an amount. And here we go to the heart of the matter. Severoceske doly does not in fact sell its lignite on the market, and it would not sell it even if the market were to offer better prices than its owner CEZ.

This is the real reason why Czech Coal’s bargaining power with EPH is strong. CEZ, not Czech Coal, has cornered the lignite market. It is CEZ’s ownership of Severoceske doly and its 25 million tons of lignite that distorts competition. And this is an abuse of CEZ’s market power, a classic example of what competition economists label ‘vertical collusion’.

EPH blames this on Czech Coal, not CEZ. It refuses to acknowledge the elephant in the room.

CEZ produces most of its electricity from lignite. It is in CEZ’s commercial interest to keep the price of lignite competitive, in other words, low. Furthermore, CEZ is both the largest supplier of lignite on the market as well as the largest consumer, buying lignite from all domestic lignite suppliers. This gives CEZ immense ‘buying power’ which it uses to drive lignite prices down –what economists call a ‘monopsony’.

Daniel Benes in his interview with Hospodarske noviny this week flexes his monopsonic muscles and displays a clear willingness to abuse this power. In response to the question of how demanding it would be for CEZ to supply Pocerady with its own coal, he issues a threat: "If we did not have coal from Czech Coal, we would not operate all blocks at full capacity. This would have some impact on our margins but it would have a much greater impact on Czech Coal's economics." I wonder whether the European Commission has read this. It should.

So much then for the argument that Czech Coal is a dominant supplier. Another hook on which EPH might wish to hang its case against Czech Coal might be the claim that Czech Coal is the only firm able to secure fuel for Pocerady. The same objection could just as well be made about the hard coal-fired Detmarovice in Northern Moravia, which is another of the power plants on CEZ’s divestment list and the one CEZ really wants to dump. If we accept the logic above, OKD would be the only possible bidder for Detmarovice because OKD can supply Detmarovice at much better terms than the market –just as Czech Coal, for reasons of location, volume and fuel type, is the ideal supplier to Pocerady.

The argument is unsound because it confuses the ability to secure an appropriate supply of fuel with actually owning an appropriate supply of fuel. Under the terms set by the Commission, the ability to secure adequate fuel supplies is an essential condition of sale to any buyer.

Even if the cost of switching suppliers is high, perhaps even prohibitive, what is to prevent a potential buyer of Pocerady from negotiating a contract with Czech Coal itself, and in this way secure the fuel supply upon which the Commission insists? After all, if Czech Coal can sell its lignite to CEZ-owned Pocerady, what prevents it from selling lignite to an EPH-owned Pocerady?

And if switching supplier is not prohibitively costly, what is to prevent an interested buyer from negotiating a contract with Severoceske doly to supply Pocerady? Daniel Benes himself admitted this week, in his Hospodarske noviny interview, that CEZ is able, if necessary, to supply Pocerady from Severoceske doly. There you are, EPH! Problem solved.

The weakness of the argument becomes ever clearer if you consider that exactly the same argument applies to the other lignite-fired plants in the divestment package. Any potential buyer of these power plants will also have to reach an agreement with a fuel supplier.

The supposition that CEZ’s lignite is not part of the relevant market makes for a very muddled argument indeed. EPH may accuse Czech Coal of trying to corner the market in lignite supplies. But this ignores the inescapable fact that lignite is abundant in this country –it is simply not abundant at the price that EPH is willing to pay, thanks to CEZ’s dominant position on both sides of the market.

I hope this post goes some way in explaining why the European Commission took Czech Coal’s 2009 complaint against CEZ seriously enough to spend three years investigating it, and why today it is hesitating to allow CEZ to choose which of the four power plants it sells.

Given the choice, CEZ would opt for Detmarovice. Such an outcome would be perfect for EPH and for the elephant in the room. It would be a bitter blow for Czech Coal –and for all household consumers of electricity.

No doubt I shall now be accused of writing this on behalf of Pavel Tykac. Tant pis!

Merry Christmas!