Equal Prices for Everybody? An Empirical Analysis of the Effects of Liberalization on Electricity Prices in Europe Using the Law of One Price

Abstract: Directive 2003/54/EC of the European Commission set the ground for an integrated and liberalized electricity market in Europe. According to the law of one price the possibility for perfect arbitrage and the absence of trade restrictions lead to homogeneous goods being priced uniformly across countries. The aim of this study is to test whether the law of one price is applicable to the electricity market in Europe. Since the electricity market has some unique characteristics such as simultaneous production and consumption and very high set up cost for the needed infrastructure, the law of one price is expected to be violated. Hence, additional distinct market features that can help explain possible differences in electricity prices across Europe are identified. Utilizing primarily Eurostat data we specify three models that capture trade, cost and institutional factors. We then estimate these models separately for household and industrial price differentials using ordinary least squares regression techniques. The overall results show that geographical proximity is decisive in reducing price gaps. Additionally, for household customers the factors behind price gaps are income and price regulation differences as well as the level of mutual trade. For industrial customers similar levels of network tariffs as well as network unbundling decrease price differences. Moreover, we find a strong positive effect of liberalization and regional integration on industrial price divergence. Overall, there is a strong conformation that the LOOP is more applicable to electricity prices for industrial customers than for household customers.