Examination of Witnesses (Questions 486-499)|
TUESDAY 4 DECEMBER 2001
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.
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
(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
492. In the future do you see that CHP and renewables
will still feel that they are being disadvantaged by the NETA
(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
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
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 reductionand a severe reductionin
generating margin, there is no evidence at all that has happened.
Mr Berry: Thank you.
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
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