House of Commons - Trade and Industry

Select Committee on Trade and Industry Twelfth Report

7 Electricity market

99. So far, we have concentrated on the gas industry but, because of the importance of gas as a fuel for generating electricity, the rise in gas prices has also had a direct impact on the electricity industry. About 35-40 percent of the UK's electricity is generated by gas-fired plant, about 35-40 percent from coal, approximately 20 percent by nuclear stations, with the balance being a small (and shrinking) percentage of oil and a small (but growing) percentage of renewable power, principally hydro but also wind. Historically, coal and oil provided a greater proportion of the mix, but they have been in decline because of environmental concerns and (in the case of oil) price.[260]

100. According to E.ON, during 2004 wholesale electricity prices rose by 53 percent.[261] During the same period, not only did wholesale gas prices rise by 71 percent, but also international coal prices increased by 55 percent.[262] The price of coal on international markets is estimated to have roughly doubled since April 2002. The reasons for the coal price increase are clear and not in dispute: China has been importing large quantities of coal which has affected both the price of coal itself and—coupled with China's massive appetite for raw materials and products like steel—has created such a demand for freight capacity that international freight prices have soared.[263]

101. The AEP suggested that, because of strong competition in the retail market, generating companies had found it difficult to pass on the extra cost of generation in full to their customers.[264] This may be so.

102. Several witnesses commented on the fact that there has been a significant decrease in the number of companies competing with one another at all levels of the gas and electricity markets. We have already mentioned the mergers within the gas production industry, and the fact that the large production companies are also shippers and trade in the wholesale market. At the same time, in the electricity industry there have been mergers to produce fewer, vertically integrated companies. This is at least partly a response to the competitive situation produced by the New Electricity Trading Arrangements ('NETA')[265], which severely penalise companies for being 'out of balance'—that is, supplying more or less electricity than they have contracted to do.[266] The strategy adopted by many companies to ensure that they can balance and avoid such penalties has been to expand their activities into all sectors of the electricity market—generation, the wholesale market and retailing to customers—and, in some cases, to acquire gas interests in order to reduce their need to buy and sell in the wholesale markets.[267] As NGT pointed out, this development had increased the capital investment needed to compete in the market, thus posing a significant barrier to new entrants and ensuring that the gas and electricity supply industries were likely to remain oligopolies.[268] It is clear that company mergers are creating gas and electricity markets dominated by a few, vertically integrated companies. We know that Ofgem monitors this situation closely to ensure that no anti-competitive behaviour emerges. However, we detect increasing unease among consumer groups, I&C customers and some companies within the industry about the possible effects of such integration.

103. The movement away from coal-fired to gas-fired generation over the last decade, together with the fact that there was a sharp decrease[269] in electricity wholesale prices in the period 1998-2004, means that in the UK a number of generating stations were either 'mothballed' or operating at very low capacity (in effect, operating as a reserve for any peaks in demand or disruptions to supply). The UK electricity industry has therefore had some ability to switch from higher cost to lower cost fuels. We were keen to explore the extent of the industry's room for manoeuvre, and how individual generating companies were approaching the problem of high gas prices.

104. We were told that there had been a seasonal pattern to the usage of different types of generation. While nuclear plant cannot be 'turned on or off' easily and also, for financial reasons, needs to run constantly, both coal- and gas-fired generation are relatively flexible. As a result, the contribution of coal and gas to the energy mix varies according to the price differential between the two, taking into account also any 'energy taxes'. Though this is a simplification, in broad terms there has been a seasonal pattern to deployment of plant. During the winter, when gas prices are relatively high, generating companies have often run their coal-fired plant at maximum capacity. As gas-fired plant is always required to meet winter demand, it has tended to set the overall price of electricity generation in winter.[270] In summer, when the gas price drops, the situation is reversed.[271]

105. The ability of different companies to take advantage of such flexibility varies, as each has a different mixture of generating plant.[272] E.ON, which generated about 22 percent of the electricity in the UK, relied on coal for just over half of its power production, on gas for about 40 percent, and the rest came from oil, wind, and other renewable sources.[273] SSE produced about 10 percent of its electricity from hydro plants but was otherwise heavily dependent upon gas as a fuel. Conscious of rising gas wholesale prices and taking advantage of the fact that the plant on offer was relatively cheap, it had bought some coal-fired generation in 2004; and this had enabled the company to avoid some of the price rises to customers which competitors had made during 2004.[274] We were told that all Centrica's generation was gas-fired, so it had been unable to mitigate the gas price rises by substituting other fuels.[275]

106. We asked whether the current fuel mix in the UK was likely to continue. SSE thought so. The AEP believed that most of its members wanted coal to continue to play a significant role in electricity generation.[276] However, our witnesses suggested that there were still many uncertainties, especially in relation to the impact of environmental legislation (such as the Large Combustion Plants Directive[277] and the EU Emissions Trading Scheme[278]) on the fuel that created most atmospheric pollution, coal. The AEP reported that its members were examining the potential of various 'clean coal' technologies including super-critical boilers (which burn fuels more efficiently), pollution abatement measures and the possibility of carbon sequestration. However, none of them was viable in the immediate future.[279] SSE thought that these developing technologies made it more likely that fossil-fuelled generation—whether coal or gas—would continue; but the company had not yet decided whether it was financially worthwhile to fit existing technology, Flue Gas Desulphurisation, to its newly acquired coal plants to make them comply with the large Combustion Plants Directive and thus to prolong their life beyond 2007.[280] E.ON suggested that it would need a substantial change in the relationship between coal and gas prices to make clean coal generation more attractive than gas-fired plant. It believed that gas, in the form of Combined Cycle Gas Turbines ( the more efficient type of gas-fired plant that has been especially popular over the last few years), would replace both the UK's ageing nuclear and its older coal-fired plants.[281]

107. More generally, several witnesses warned that the price of electricity in the UK was likely to increase further because of the various environmental measures due to come into force shortly, particularly the Large Combustion Plant Directive and the EU Emissions Trading Scheme.[282]

108. Although some individuals who wrote to us felt that the electricity price rises for consumers were unjustified, the vast majority of our witnesses accepted that they were a direct result of the increase in the cost of the main generating fuels, coal and—especially—gas. We, too, believe that electricity producers have not been profiteering. The variations in price rises from company to company can be explained in part by the differences in their portfolios of generating plant and the degree to which they have been able to offset the gas price rises by changing to cheaper fuels; and in part by the different commercial approaches they have adopted (whether they have chosen to increase prices across the board or to shelter some customers from the full effects of the price rises, for example).

109. However, the effect of the price increases on customers has been significant, and further increases are inevitable, given that the cost of environmental legislation has yet to be passed through to customers. We note that the cost of the Large Combustion Plant Directive and the EU Emissions Trading Scheme will add to the existing cost of the Renewables Obligation and the Climate Change Levy. When our predecessors first considered the Climate Change Levy, they reported industry's fears that they would be subject to both the Levy and, shortly afterwards, an emissions trading scheme.[283] We noted that even Greenpeace considered that the Levy should be used to ensure a continuous, planned, gradual rise in electricity prices and should not impose additional costs when electricity prices had risen for other reasons.[284] Electricity prices have now risen in response to increases in fuel costs, and will rise further when the costs of other environmental legislation are passed through. Although fluctuations in fuel costs will occur, over the medium to long-term electricity is unlikely to be as cheap in real terms as it has been over the last six years. I&C customers have considerable incentives to reduce their energy use. As a result, we think that it is now time for the Government to re-examine the operation of the Climate Change Levy, and in particular to consider the scope for reducing it to help UK industry during its present difficulties.

260 Security of Energy Supply Report, paragraphs 8 and 51-52 Back

261 Q 320 Back

262 Ibid. Back

263 Qq 318-319 (E.ON) and 77 (AEP) Ofgem said that during 2004 the international coal price rose from $30 a tonne to between $60 and $70 a tonne, and freight charges tripled. As well as the 'China effect', Japan needed to import significant extra quantities of coal because a number of its nuclear power stations - with a total output of 15 Gigawatts - were out of production: Q 478 Back

264 Q 95 Back

265 Which came into effect in 2002 Back

266 For more information about the operation of NETA, see our Security of energy supply Report, paragraphs 60-61 and 63 Back

267 Qq 39 (energywatch), 87-88 (AEP), 361 (NGT) and 390 (Centrica) Back

268 Q 361 Back

269 Of 22 percent in nominal terms, 31 percent in real terms: DTI's Quarterly Energy Prices, December 2004, Chart 3.1.2 on p27 Back

270 In technical terms, gas has set the marginal cost. Back

271 Qq 78 (AEP), 314 (E.ON) and App 14 (E.ON), para 30 Back