A theory of why CEZ and EPH work so well together.

Earlier this week, I promised to address the question posed (but not answered) by Lenka Zlamalova of Lidove noviny. The question, in her words, was: "Why is EPH allowed to earn so much money at CEZ's expense?"

At the outset, I should point out that this is a very loaded question indeed. The healthy profits announced by EP Energy for the first three quarters of 2012 throw less light upon the relationship between the two energy firms than is so heavily implied by Ms Zlamalova's question.

Half of the Kc 8.5 bn profit is explained by the revaluation of assets, an accounting manoeuvre which makes it look like EP Energy made a killing on two transactions with CEZ -the sale to CEZ of the lignite-fired Energotrans plant, and the purchase of CEZ's stake in the German lignite mine MIBRAG.

Naturally, both sides claim that the transactions made good business sense for them, and proving otherwise is impossible without access to the accounting of each firm. We might suspect that EPH has been ‘allowed to make lots of money at the expense of CEZ’, but proving this is an altogether different matter. Nevertheless, an examination of the business rationale behind the transactions is well worth making.

One of the keys to understanding the relationship between CEZ and EPH is their mutual determination to block Czech Coal's ambitions to acquire and/or to build a lignite-fired power plant in the Czech Republic.

Readers of Czech newspapers will have noticed how Czech Coal is usually portrayed as the villain in its fuel supply disputes with its customers. But this may be misleading, especially when it concerns the firm's disputes with CEZ. This is because it overlooks or downplays the crucial fact that CEZ, not Czech Coal, dominates the relevant lignite market.

The economics are straightforward. CEZ produces most of its electricity from lignite. It is therefore in CEZ's interest to keep the price of lignite, its most important fuel source, competitive, in other words, low.

It is not only in CEZ's interest to keep lignite cheap -more importantly, it is in its power to do so. CEZ is the largest supplier of lignite on the market. But its also the largest consumer as well, 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 recent interview with Hospodarske noviny, flexes his monopsonic muscles in a characteristically crude fashion, displaying a clear willingness to abuse this power. The lignite-fired Pocerady power plant is owned by CEZ and today supplied by Czech Coal. In response to the question of how demanding it would be for CEZ to supply Pocerady power plant 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." So be warned, Mr Tykac!

CEZ's power to 'make', rather than to 'take', the market price of lignite is an essential part of its ability consistently to generate economic rents and to block new entrants who might like to take advantage of the cost competitiveness of the Czech Republic. More than half of the coal that CEZ consumes is sourced from CEZ's own mines, which makes its coal-fired generation fleet mostly fixed-cost. If you are looking for an explanation of why CEZ makes so much money, there you have it.

It is clear, then, what motivates CEZ in this matter. But why would EPH want, or even help, CEZ to preserve its monopsonic power over lignite? The answer is simple: EPH –and not only EPH, enjoys a parasitic relationship with CEZ, free riding on CEZ's market dominance. For as long as CEZ is able to exert this significant buying power and to distort access to the most important fuel source, it is able to maintain its dominant position and the abundant economic rents that result. And EPH is granted privileged access to these rents, presumably in return for its support of CEZ.

The trouble is that CEZ's behaviour must be considered an abuse of dominant market power. If CEZ's own lignite was freely-traded, then, as its price increases, it would be sold on the market, instead of being delivered only to its owner, CEZ. But CEZ's Severoceske doly does not sell on the market in response to price increases.

The intervention of the European Commission has threatened to complicate this cosy arrangement. The European Commission might yet oblige CEZ to sell the lignite-fired Pocerady plant as a result of its investigations into abuses into the Czech energy market, investigations which were, of course, initiated by the dastardly Czech Coal.

This possibility appalls both CEZ and EPH because the obvious buyer for Pocerady is Czech Coal. This would make Czech Coal much less dependent upon its two biggest customers, CEZ and EPH, which would allow it to negotiate better terms with them both in future.

That, for CEZ, is the slippery slope to price-taking, and to a dent in the earnings of both CEZ and EPH. In the case of CEZ, this dent could be rather significant given its high exposure to lignite as a fuel source.

So much for the theoretical underpinnings of the happy relationship between CEZ and EPH.

In Part Two, we shall take a look at the recent transactions between them, transactions which in our view illustrate how well CEZ and EPH work together in practice to achieve their shared goal of weakening Czech Coal.