Conclusions and recommendations
Impact of price increases on business customers
1. The
recent gas and electricity price rises have created major problems
for the competitiveness of UK manufacturing industry. As the EIUG
suggested, industry would be able to live with these problems
if it felt that the competitive disadvantage would shortly disappear—after
all, UK industrial consumers have experienced a relatively long
period of below average fuel prices to offset the recent peak,
and such fluctuations are an integral part of a liberalised market.
However, industry fears that the autumn 2004 price spike will
not prove to be an isolated incident, partly because one cause
of it was the lack of liberalisation in European Markets which
will not be rectified quickly, and partly because it feels the
spike has not been fully explained by market fundamentals and
is probably a symptom of serious market failure. We believe such
a failure could be attributed to supply side rigidities. We return
to this issue later. (Paragraph 24)
2. We accept that
the overall statistics mask significant price imbalances between
individual UK companies and sectors and their competitors in Continental
Europe. However, we note that Continental supply contracts also
usually contain provisions for a time lag of between three and
nine months before customers are affected by any price increases
in the commodities to which the contract is indexed. We suspect
that I&C customers on the Continent will soon experience higher
prices for gas too—E.ON confirmed that this was already
beginning to happen in Germany. This would reduce the competitive
disadvantage experienced by a number of UK companies. (Paragraph
15)
3. Industrial customers
continue to run the serious risk of paying much higher prices
for their energy if they opt for the stability of annual contracts
over the risk associated with shorter-term contracts. They must
make this decision for themselves. However, we urge trade associations
and the DTI to work quickly to provide (especially smaller) business
customers with the information they need about options. We also
think that companies should seriously consider disconnecting their
energy contracts from the October renewal date: although annual
contracts should smooth out the seasonal price peaks and troughs
whatever the starting date, the effect of so many contracts being
renewed at the same time would tend to make it a sellers' market.
(Paragraph 25)
4. In this context,
we were pleased to hear from the Minister that the DTI intended
to hold a seminar early in spring to enable I&C customers
to discuss different purchasing strategies and to share ideas
on how they might reduce the problem of the autumn price spike
by smoothing out the bunching of contract renewals. (Paragraph
26)
5. Universities and
Public Sector bodies have experienced particularly sharp price
rises. We expect the DTI to include them in the proposed discussions
with industry on how to cope with the price rise. (Paragraph 27)
Impact of price increases on domestic customers
6. energywatch
and the Fuel Poverty Advisory Group advocated a number of actions
that could be taken to mitigate the effect of the price eases
on poorer customers. We endorse all these suggestions, which repeat
our recommendations over a number of years in our Reports on various
aspects of fuel poverty. It is clear that the long term solution
to the problem of fuel poverty must not rely on low energy prices.
We note Ofgem's assurances that some of the necessary responses
are already happening—for example, the development by companies
of innovative tariffs, and continued pressure by the regulator
for companies to follow best practice guidelines on dealing with
customers in debt. (Paragraph 32)
7.
However, more efforts are required. We particularly emphasise
the need for greater co-ordination within Government to deploy
key providers of public services (especially in the fields of
health, social services and social security) in the task of identifying
those in fuel poverty and informing them where they can obtain
advice and help. (Paragraph 32)
Social responsibility of production companies
8. Since
we started this inquiry, a number of oil companies operating in
the UKCS have announced record profits. These are multinational
companies producing both oil and gas, and it would be wrong simply
to assume that much of this profit is attributable directly to
the dramatic increase in UKCS gas prices. We also acknowledge
that the production industry is subject to a higher rate of Corporation
Tax than other sectors. Some of our witnesses advanced arguments
for a windfall profits tax, but we have received too little specific
evidence on its potential impact on future investment in the UKCS
to report on this issue. However, if the current very high levels
of world oil and gas prices continue and if a specific proportion
of the profit can be identified as coming from the UKCS, then
we believe that the Chancellor of the Exchequer should carefully
consider the options. We would prefer those companies that have
benefited from the price rises voluntarily to contribute to the
alleviation of fuel poverty as part of their Corporate Social
Responsibility programmes: it would enhance their reputation and
would provide help more swiftly to those who, though unable to
afford it, are contributing to their unearned profits. We do not
expect the production companies to set up fuel poverty programmes
themselves—as they pointed out, government agencies and
the energy supply companies are much better placed to identify
those in need of help and deliver that help. But we do not believe
it would be difficult to devise a mechanism through which they
could donate money to such schemes. (Paragraph 36)
Decline of the UKCS
9. Because
of the difficulties in extracting the—substantial—remaining
reserves of gas from the UKCS, it is not at all clear that the
decrease in production will take place in a managed and predictable
way. This simply highlights two points which we address later
in this Report: the need urgently to put in place infrastructure
to ensure that adequate supplies can be imported into and stored
in the UK to meet any shortfalls from the UKCS; and the need for
sufficient information to be supplied to the market about why
production rates are lower than expected, in order that the market
players can then take a more rational view of pricing. (Paragraph
42)
Gas storage
10. As
we discuss below, there are currently plans to build significant
storage capacity in the UK. However, this does not help with the
immediate problem of a tight supply over the next year to 18 months.
Both Ofgem and the DTI suggested that the price spikes had provided
strong market signals that extra storage capacity was necessary.
So they have, but even before the price spikes it was absolutely
certain that storage would be needed as the UKCS declined: we
pointed out the consensus on this issue in our January 2002 Report
into the Security of Energy Supply. We are therefore disappointed
by the lack of progress in the last three years. We recognise
that this is not entirely due to lack of foresight: because of
difficulties in obtaining planning permission, construction has
begun only recently of the storage facility in Cheshire which
we were told in the winter of 2001-02 would shortly be built.
As one of the witnesses from Ofgem indicated, the tight supply
situation this winter would have been significantly eased if even
one of the proposed facilities had already been built, and both
domestic and I&C consumers might have been spared a proportion
of the recent price increases. Planning guidelines should be reviewed
to ensure that the strategic importance of gas storage and other
infrastructure projects is fully recognised. (Paragraph 48)
Overall supply situation
11. Over
this and perhaps the next two winters, the UK will be in the uncomfortable
position of having a relatively small surplus of gas over normal
winter demand. As National Grid Transco has indicated, because
supply cannot be increased measures may have to be taken to decrease
demand—which means that customers with interruptible supply
contracts may find their gas supply temporarily suspended. Although
the existence of the price spikes seen over the last six months
is explicable by the actual state of supply in relation to demand,
it seems to us that the degree of volatility is not fully explained
by this. (Paragraph 49)
Behaviour of the gas market
12. Although
we are not suggesting that the shipper subsidiaries of production
companies are able to buy gas at a lower cost than external competitors
can—we accept that the transfer price of gas sold to the
shipper arm by the production company is scrutinised closely by
the tax authorities—such vertical integration between producers
and shippers may give shippers better access to pertinent information
than other market participants. (Paragraph 51)
13. We received no
evidence that producers have withheld supply from the market to
drive prices up. None of our witnesses has suggested collusion
or any other illegal behaviour in the offshore production market;
nor do we consider that the sharing of information between companies
owning or making use of the same facilities is improper or unnecessary.
However, the structure of the UKCS production market does mean
that participants in it have access to significantly more knowledge
than those to whom they are selling their gas. We note also that
there have been allegations in the past that the oil majors have
shown a disinclination to share infrastructure with newer market
entrants—a situation that, the industry hopes, it has addressed
by a new Code of Practice "to ensure equitable and timely
access to infrastructure", which was launched in September
2004. These factors, together with the fact that the big gas production
companies also act as shippers, result in a market where actual
competition appears less than might be expected from the number
of players and market share. This leads to a further question,
which is whether the market therefore needs to be regulated or
made subject to closer monitoring. (Paragraph 58)
14. There is a serious
shortage of companies willing to sell gas in the wholesale market
when prices are high. Unfortunately, because of the tight supply
situation, prices are likely to remain high over the next two
years. This does not bode well for I&C customers. We hope
that Ofgem's prediction about the imminent arrival of more active
traders proves correct. Perhaps—if they are financial institutions
themselves—they will not be subjected to as tight a credit
straitjacket as current market traders, and greater liquidity
will return. However, we can only conclude that at present the
market is not functioning efficiently. Price spikes are more and
more frequent, and they seem to be higher each time. Much of the
volatility can be attributed to real difficulties in balancing
supply and demand, but the scale of the peaks will remain high
until more traders are encouraged to sell short. (Paragraph
65)
Transparency of the gas market
15. We
understand and accept NGT's explanation of why it is currently
impossible to provide real time information on gas flows. This
may not be very significant: information delayed by an hour represents
a huge increase in the transparency of this market, and is, we
believe, quite sufficient for the needs of customers. However,
we suspect that to restore market confidence there may be a need
for still more information about production outages, not least
because of the mistrust that has arisen over maintenance patterns
in 2003. It is too soon to make a firm judgement on this, but
we recommend that the DTI and Ofgem keep a watch on this area
to see whether further information is needed. (Paragraph 72)
16. We note that the
Norwegian gas production companies have agreed to participate
in the arrangements for providing voluntary information. We welcome
this. We consider that the advantages of receiving information
from all major parties, albeit on a voluntary basis, outweigh
any benefit from imposing any element of compulsion which might
lead the Norwegian companies to withdraw from the scheme altogether.
(Paragraph 73)
Oil indexation in gas contracts
17. Because
of the variety of ways of determining future price increases under
long-term gas contracts, it is impossible to come to a firm conclusion
about the degree to which UK gas prices have been affected by
the increase in prices of crude oil and some oil products. The
effects will vary markedly from company to company. There seems
to be a strong trend to replace oil indexation in contracts as
they come up for renewal. There was a consensus that this trend
was likely to be beneficial in the medium to long-term. However,
there is no guarantee that gas prices would fall if oil indexation
ended. Shell cited the example of the USA where—it said—there
was no indexation to oil but gas prices had increased significantly,
being at higher levels during the winter of 2004-05 than in both
the UK and Continental Europe. (Paragraph 79)
18. Oil and gas prices
will to some extent tend to move together even if the explicit
indexation to oil is broken because oil and gas are still, to
a degree, competitive products. However, what the actual correlation
between the two will be remains unclear. (Paragraph 80)
Competition within Europe
19. We
welcome the European Commission's announcement of inquiries into
competition within the European gas and electricity markets. We
note the timetable announced to us, and look forward to the completion
of both inquiries by the end of 2006. We are also pleased that
the UK Government has taken such a firm stand on the centrality
of energy liberalisation to the whole Lisbon Agenda. However,
we recognise that both the Commission and the UK Government will
need to exercise considerable persuasive powers to convince other
Member States of the need to take prompt action. (Paragraph 90)
20. Without further
real (not just cosmetic) liberalisation of the European gas market,
the wholesale market in the UK will malfunction: it will continue
to be difficult for buyers to access adequate supply and, because
of this and other distortions caused by the mismatch between the
liberalised market in the UK and the more rigid contractual arrangements
on the Continent, there will be a tendency for prices to diverge
significantly. Even on the most optimistic forecast, it is unlikely
that the Continental market will be functioning as a fully liberalised
one before about the end of this decade. Moreover, as BP reminded
us, "Liberalisation does not, per se, lead to lower prices.
Rather it gives consumers the freedom to choose suppliers, encourage
the development of new products and services and lets the market
react more quickly to changes in supply/demand fundamentals."
European liberalisation is not a complete answer to the problems
in the UK gas wholesale market. In fact, the Director for Conventional
Energies, Directorate General for Transport and Energy, observed
that the object was not cheap energy but rather a more efficient
mechanism for establishing energy prices. (Paragraph 91)
Regulation of the gas market
21. The
DTI and Ofgem consider that the current regulatory regime is robust;
they base this view on their assessment that the gas market is
competitive. We believe that some of the peculiar aspects of gas
production and trading militate against full competitiveness at
present. The result is a loss of confidence in the market, and
suspicions by gas users that those benefiting from price spikes
have somehow engineered them. None of our witnesses suggested
any failure of the market in respect of areas wholly subject to
the sectoral regulator, Ofgem: concerns focussed on the supply
of gas to the wholesale markets, not the 'downstream' operations.
We acknowledge that any extension of Ofgem's remit would require
primary legislation, which would mean delay, when the problems
of supply/demand balance in the gas market are likely to be at
their worst over the next two years or so. Furthermore, attempting
such legislation would undermine investor confidence at this crucial
time. (Paragraph 97)
22. We therefore recommend
that the DTI itself should take a more active role—not necessarily
by increasing its intervention in the offshore industry but by
monitoring the situation more closely to ensure that there are
no activities which would warrant referral to the Competition
Commission. We accept that such an increase in activity may require
greater staff resources within the DTI; we would expect extra
resources to be made available, if required. (Paragraph 98)
Vertical integration in the gas and electricity
industries
23. 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.
(Paragraph 102)
Electricity market
24. 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). (Paragraph
108)
25. 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. 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. (Paragraph
109)
New infrastructure projects
26. We
have no doubt that the UK will shortly have significant extra
import capacity, but we cannot predict when construction of this
capacity will be completed. We note that, between UKOOA's submission
of its original Memorandum to us in late November 2004 and the
production of its Supplementary Memorandum in mid February 2005,
the target dates for completion of three facilities had been put
back, and there had been a reduction in the expected capacity
of two facilities (including Phase 1 of the Isle of Grain LNG
facility, which is likely to be the first to come into operation).
This is in the nature of large infrastructure projects. However,
this does prolong the uncertainty to which the wholesale gas market
is prey. Government departments should ensure they are well placed
to facilitate these developments where they have a regulatory
or planning function. (Paragraph 112)
Future of gas prices
27. We
cannot take the Panglossian view of the gas wholesale market that
the DTI and Ofgem appear to hold. There are failures in the market
which arise from significant problems with physical supply, the
lack of information about supply available to participants, the
difficulties caused by operating a liberalised market (the UK)
alongside a relatively unliberalised market (Continental Europe),
and the dearth of traders willing to sell gas into the forward
market. These problems are serious enough for us to conclude that
the autumn 2004 price spike, and the recent spike in late February,
will be repeated over the next two years. We urge Ofgem and the
DTI to keep a close watch to ensure that the market is responding
to all the proposed developments likely to make it function efficiently
(extra infrastructure and storage capacity, the provision of more
information, and so on). If there continue to be well-founded
concerns over the operation of the market after these changes
have taken effect, then we conclude that the market must be considered
to be failing. (Paragraph 116)
28. Although all the
problems with the market could, and probably will, be solved eventually,
customers—and especially I&C customers—will face
serious disadvantages in the meantime. The DTI is placing heavy
reliance on customers changing their buying practices: avoiding
the October bunching, and purchasing gas on short-term markets
when forward prices seem excessive. We think that this is going
to be difficult for companies, especially the SMEs whose interests
the DTI has pledged itself to take particularly into account.
(Paragraph 117)
| 
