Select Committee on Trade and Industry Minutes of Evidence

Examination of Witnesses (Questions 486-499)




  486. Good morning, gentlemen. May I welcome you, Mr McCarthy. Could you introduce your colleagues and I think we will try and start.
  (Mr McCarthy) Certainly, Chairman. On my left I have got John Neilson, who is the Managing Director of Customers and Supply of Ofgem, and on my right, Steve Smith, who is the Director responsible for trading arrangements.

  487. Thank you. I am sorry about the delay but fortunately it was not too much. May I start off. A theme which is running through your evidence suggests that the market will deliver security of supply if we just let it get on with it. We have already had misgivings expressed to us about the nature of the ownership of the pipeline grid on the continent of Europe and the fact that in the hands of, for example, Ruhrgas there is a company there which is not liberalised, which has not separated its functions, whose responsibilities are to shareholders and to the people of Germany and to sustain their supply. Is there not a danger that if we do not get liberalisation of the energy businesses in France and in Germany that we could find ourselves denied access to the supplies of gas from the former Soviet Union and the states of Central Asia because there would be a block, as it were, in North-West Europe or West Central Europe, as it were? Have you taken account of that in your thinking?
  (Mr McCarthy) The answer, Chairman, is yes because, like you, we believe that it is important to disaggregate what is meant by security of supply into different component parts. I do not think Ofgem has any contribution that it can make on the geopolitical issues, but one of the issues that we think of as important and one of the issues that we specifically flagged up in our evidence to the PIU study on energy policy that is going to report to the Government in the next month was the need to liberalise the European transmission networks, both in gas and electricity. We regard that as one of the important components in establishing and maintaining security of supply and we are working as closely as we can with Government, which has the principal responsibility, to support the Government in doing that.

  488. What you are saying is that assuming we can get liberalisation within Europe this will not be a problem, but it has been anticipated in a relatively short time that we could become significantly dependent upon gas and, indeed, on an element of imported gas, and that will have to go through what are at present unliberalised energy markets?
  (Mr McCarthy) I think it is important to look first of all at where our imports of gas are likely to come from. In the short-term, when Britain becomes an importing country, which has always been on the cards, that it would become an importing country, the two nations which are likely to be the principal sources of gas are in the first instance Norway and in the second instance the Netherlands. After that, and in due course, there will be undoubtedly some reliance on gas from both Russia and Algeria. The question that I think arises over that timescale is: are the rules for the access to the transmission system going to be such that the economics of it are not distorted.

  489. Thank you. Can I just ask you another question related to the three player market forces. One of the tendencies of markets is towards market dominance and the shutting out of one player as against another. We have seen already the move away from coal to a market dominated by gas. To what extent do you see diversity as being an essential part of security of supply? Given the point you have made about access to Norwegian and Dutch supplies in the short-term, that will get us over the hump and beyond that we should have a near liberalised market in Europe which should enable the supplies to come flowing through, are you quite, I do not want to say relaxed but do you feel that we could accommodate a dependence on gas generated electricity to the extent of something like 70 per cent of our supplies?
  (Mr McCarthy) Subject to a number of qualifications I think my answer to that is yes, we could accommodate a position where we had 70 per cent of electricity generated from gas. I think it is important to recognise that it is not obvious that that is going to happen. The history of predictions of what is going to happen over a 20 year period is very poor indeed. If you go back to the time of the Sizewell inquiry, which was only 20 years ago, to find the forecasts that were then made of reliance on different energy sources, there is a very salutary lesson about how difficult it is to predict. The qualification I would make is provided there is genuine competition in the provision of gas, which we do have at the moment in terms of the number of producers, and provided there is proper access.

Linda Perham

  490. The report you did on the impact of NETA on small generators clearly identified the problems for the CHP and renewables sectors. To some extent these problems were predictable. In fact, when we saw the Minister earlier he acknowledged that they had been predicted, but not resolved. Do you think that the solutions should have been in place before NETA came into operation?
  (Mr McCarthy) I think it is important to establish the slightly different position of CHP and renewables. If you take CHP, the central problem about CHP is that one of the effects of NETA has been to reduce wholesale electricity prices by between 20 and 25 per cent, and that has affected all generators, including CHP generators. At the same time gas, which is the principal supply for CHP, has risen in price by something over ten per cent, certainly over ten per cent. The result of that is CHP has been squeezed. There are quite a lot of CHP producers who say it is now more economic to take the gas that they are contracted to buy and sell it on, and that is just an economic fact of life, not related to the specifics of NETA. If I look at the criticism that is normally made of NETA in relation to CHP and renewables, it relates to the spread between what is known as the system buy price and the system sell price. NETA has been going now for just five or six days over eight months. During that time the spread between those two has come down by well over two-thirds and it has come down for two reasons: one is because people are learning to operate under this totally new system, and the second reason it is coming down is we have encouraged and passed a number of modifications designed to reduce that spread. I think it was always inevitable that there would be a learning experience during NETA. I do not think it would have been possible to predict it or to have anticipated it further as I think that we are operating rather faster within the fact that we are dealing with large systems which establish some time constraints on the speed at which you can make changes, and to make changes designed to help eliminate these problems.

  491. The DTI responded to your report. Do you have any comment on the options that they put forward which you would favour?
  (Mr McCarthy) I think I have two concerns. One is that we do not rush into making changes which are likely to have some short-term benefit but some long-term disbenefit. The second is a concern that we should work hard, as Ofgem is working hard, with the companies, to ensure that the process known as consolidation works effectively. That is the area that we are concentrating on.

  492. In the future do you see that CHP and renewables will still feel that they are being disadvantaged by the NETA position?
  (Mr McCarthy) I am almost tempted to say that you will have to ask them.

  493. We have.
  (Mr McCarthy) I am sure that they will always, because they are powerful and well articulated lobbies with particular interests, say that is so. The question is are they being treated unfairly and, truthfully, I think the changes that are being made make it very difficult to argue that they are going to be treated unfairly.

Mr Berry

  494. Mr McCarthy, in your memorandum you make a fair point that as a result of increased investment in capacity the generating margin over average demand is more than 30 per cent. I am trying to work out what significance I attach to that figure of 30 per cent. Is that, in your view, about right or is it too much or is it too little?
  (Mr McCarthy) I think the reason why we are making that comment is because if you go back to the time of privatisation it was lower than the present figure of 34 per cent, it has been lower many times over the last 12 years, and there have not been significant problems of lack of generating capacity. The rather simple point that we are making is that unlike the position when reforms were made in some other places, we are starting off from a position of very significant margin of reserve.

  495. Does it suggest that you have another view about the target level of excess capacity?
  (Mr McCarthy) I think that one of the things that we would want to do is to constantly monitor what is there and make sure that figure is known to the market. I think our view on the way in which that will happen in terms of getting new investment is as that capacity margin comes down we would expect the forward price for electricity to increase and to give people an incentive to invest. That is the process that we will be monitoring very carefully indeed.

  496. Can I get this right. So in a sense telling the market what the figure is, although I guess the market probably has some idea, are you really saying that you do not regard it as a policy objective to have any particular attitude towards excess capacity, you believe that market forces will generate the appropriate capacity? If the prices rise there will be more capacity and that is the end of it. It is essentially not a target of your policy, it is that you need to know what the market forces will come up with?
  (Mr McCarthy) Yes. We are saying that the evidence so far is that unlike the position that some people predicted, that that would lead to a reduction—and a severe reduction—in generating margin, there is no evidence at all that has happened.

  Mr Berry: Thank you.

Mrs Lawrence

  497. Looking at item four of your memorandum, Ofgem suggests that the present arrangements need to be improved in two important respects. If I can turn to the first of those. There does seem to be fairly broad agreement that the RPI-X formula for regulating the transmission networks has had its day, but there is less certainty as to how to replace that. How is work on the replacement of the formula proceeding?
  (Mr McCarthy) I am not sure, Chairman, whether I agree with the assumption behind the question and it is in the interests of clarity that I should say so. If you look at the criticism that is normally made of RPI-X it is in terms of it may have been useful immediately after privatisation in doing what is normally described as sweating assets but is actually a deterrent to investment, that is the criticism. The evidence in electricity, where that criticism is often made, does not support that claim at all. Investment in the distribution networks is now 20 per cent higher than it was at the time of privatisation in real terms. In the networks as a whole there has been an investment of £30 billion over the last ten years. All the evidence of reliability shows improvement, quite significant improvement, in both electricity and gas over the last ten years. There is no evidence that there is difficulty in attracting capital in that the acquisitions of companies that have taken place since any price review that Ofgem has done have been at a very significant premium to the regulatory asset value. There is absolutely no evidence in either gas or electricity of under-investment in the networks. Now, having said that, our concern has been that RPI-X was essentially a revenue cap and did not do enough to define outputs. In all the reviews that Ofgem has done we have been concerned to establish essentially what we are buying with the revenue allowance that we are giving to a company and have defined the outputs in terms of the service standards that will be delivered to customers in a particular area for the distribution companies for electricity. We are going to do the same for gas in relation to each LDZ for setting new standards, for example, for multiple interruptions, which is a problem, and critically for both NGC and for Transco setting something called system operator incentives which will give them clearer incentives to invest money in a timely way in new investment. Those are the changes that we think are sensible changes to add to RPI-X so that they are not, as it were, throwing the RPI-X out of the window because in electricity and gas we still think it is serving us very well.

  498. So it is adjustment rather than replacement?
  (Mr McCarthy) Yes.

Sir Robert Smith

  499. On the introduction of capacity auctions for gas from the UK Continental Shelf at St Fergus, there was criticism that this did not send signals for further investment and a concern that it undermined the development of the North Sea. Is that a concern you share?
  (Mr McCarthy) The criticism, I think, centred on the fact that in order to introduce what we think is the right way of doing it, which is long-term auctions, we had to start off with short-term auctions. I think it is a fair criticism of short-term auctions that the market signals that they give are very limited. One of the interesting things is that since those original short-term auctions, as we have explained the policy in terms of long-term auctions, there has been a widespread recognition of the benefits that these will give to producers in terms of the firm property rights that they will have extending out to a number of years. Ofgem, I think, is very heartened by the fact that the attitude of the Offshore Operators' Association of major companies, including Statoil, including BP, including Total Fina Elf, has been a move to saying "yes, we understand the benefits that will come from long-term auctions" and they have moved their attention, absolutely properly, to the question that will exercise us over the next six months, which is the design of those long-term auctions to make sure that the technicalities actually deliver what both sides want.

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