APPENDIX 2
Memorandum by British Gas
EXECUTIVE SUMMARY
There are two clear drivers of gas wholesale
price increases. The first is the tightening of supply and demand
as a result of the depletion of UK continental shelf assets, and
the second are higher oil prices affecting European gas prices
and some index linked UK contracts.
With gas fired generation accounting for 40%
of UK electricity supplies, electricity prices are being affected
by the increases in wholesale gas prices. They have also been
affected by a number of environmental costs such as the introduction
of the Renewables Obligation and the EU Emissions Trading Scheme.
Whilst Centrica has tried to absorb some of
the wholesale price increases, the size of increase has meant
that it has been forced to increase its retail prices. Despite
these recent price increases, UK energy is still far cheaper than
Continental Europe where domestic competition has still to be
implemented.
Low energy prices have been a key factor in
reducing the levels of fuel poverty. Centrica is sensitive to
the effect that the recent price increases will have on vulnerable
groups and has introduced a number of measures to mitigate the
impact. However it believes there are a number of other initiatives
which need to be taken by Government, particularly around benefit
take-up, to limit the impact of price increases.
Centrica would expect downward pressure on prices
but believes that three key actions need to be taken if this is
to be achieved. In particular, Centrica believes that:
— The market needs greater transparency
of UKCS gas supply and energy trading information. This should
be extended to include critical European infrastructure as the
market develops, including current and future interconnectors.
— Investment in new infrastructure
is needed to ensure new and diverse sources of gas flow to the
UK, including pipelines and LNG terminals to ship gas from outside
the UK continental shelf. Centrica has already announced its commitment
of £12 billion to bring future supplies of energy to the
UK.
— It is vital that the UK Government
and OFGEM place the issue of European energy market liberalisation
higher up their agenda. With the UK Presidency of the EU in the
second half of 2005, there is a good opportunity to put this as
a priority item on the agenda. This is critical to ensuring future
supplies from Continental Europe can be cost effectively transported
to the UK.
1. INTRODUCTION
1.1 Centrica plc was created in February
1997 out of the demerger of British Gas plc. In the UK, it trades
under its brand names, British Gas, Scottish Gas, Nwy Prydain,
Dyno Rod, Centrica Business Services, Centrica Energy and One-Tel.
It supplies around 12.3 million residential customers with gas
and has built up an electricity business of 6.2 million customers
since the market opened to competition. The company is also active
in the industrial and commercial gas and electricity markets with
over 0.9 million customers. Under the British Gas brand, the company
sells a range of home service products to around 4 million customers
and is the market leader in delivering energy efficiency advice
and products to consumers.
1.2 Like many energy suppliers, Centrica
is reliant on UK Continental Shelf (UKCS) and upstream producers
for the supply of energy to its customers. In order to ensure
there is a secure supply for these customers, Centrica owns both
electricity and gas upstream production assets which supply approximately
a quarter of its customer needs. The remainder of the gas and
electricity that the company requires to supply its customers
is acquired through a mixture of short and long-term contracts
or in the wholesale gas markets. As a result, high wholesale prices
have a considerable impact on the price it pays to purchase energy
for its customers.
1.3 Centrica also owns the UK's largest
storage facility, Rough, and is one of the leading energy traders
in the UK. Through the Bacton-Zeebrugge interconnector it trades
gas with mainland Europe, and in recent years it has entered the
Continental European market with supply businesses in Belgium
and in Spain. It also operates in North America.
1.4 Centrica welcomes the Select Committee
inquiry into fuel prices. Wholesale gas prices have been at an
unprecedented high and this has fed through in turn into higher
electricity generation prices and higher retail gas and electricity
prices.
1.5 This response explains:
— What is happening to wholesale gas
prices?
— Why are wholesale gas prices rising?
— Why have electricity prices risen?
— The impact on domestic consumers,
including the fuel poor.
— The impact on industrial and commercial
consumers.
— Whether we will see prices come down
over time?
— What can be done to address the problem
including the roles to be played by OFGEM, the Government and
the European Commission?
2. What is Happening to Wholesale Gas Prices?
2.1 The above graph shows historical gas
prices (based on the month ahead prices) up to the present time
and the current forward gas price curve. It clearly shows the
steady increase in gas prices since autumn 2003. At its peak the
forward price for 2005 was nearly 140% higher than the price in
2003; it has now fallen to a level some 65% higher than 2003.
2.2 From late September to mid October of
this year, we saw very high winter prices in the gas forward market.
We believe this represented a period of disconnection between
the market for forward gas products and the spot gas market (which
reflects the physical matching of gas demand with supply). In
a more liquid market we would expect the prices in the forward
and the physical spot gas markets to be more aligned.
2.3 Over the last month, we have seen a
general decrease in forward market prices towards the levels supported
by physical supply/demand fundamentals. In particular, we believe
this reflects a relatively mild start to the winter, some weakening
of oil prices and a greater confidence in supply availability.
However, forward prices are likely to remain volatile given the
likely ongoing movements in oil prices and the potential for renewed
concerns over supply availability (eg based on any supply side
incidents that may occur during the remainder of this winter,
such as unplanned maintenance on a gas platform).
3. Why are wholesale gas prices rising?
3.1 There are a number of reasons for the
increases which can explain, in part, the reasons as to why prices
are so high. These are:
3.2 Reduced liquidity in the traded market:
3.2.1 Following the exit of American
companies such as Enron, Dynergy and TXU, the lack of truly speculative
traders willing to go short in the market has reduced the long
term liquidity in the traded market. This decline in the number
of players prepared to trade in the market combined with increased
consolidation in upstream markets has led to increased volatility
in prices.
3.3 Decline of UKCS
3.3.1 The UK energy environment is
rapidly changing. After decades of being self sufficient in gas,
we expect the UK will become a significant importer of gas from
the winter of 2005 for the first time in many years. This is not
a problem in itself—most other industrialised countries
have been importing gas for years and indeed the UK has been a
net gas importer in the past—but it does mean that the era
of cheap energy is over.
3.3.2 The shortage of supply for the
next two winters, combined with recent outages of fields and a
failure of the interconnector to respond to market signals, has
resulted in a reduced number of traders prepared to sell their
gas going forward.
3.4 Continental European gas market
3.4.1 As the UKCS declines, the UK
is increasingly dependent on imported gas from Continental Europe,
especially during winter periods. Since the construction of the
Bacton-Zeebugge interconnector, the UK gas market has effectively
become part of a wider North-West European gas market, subject
to influences from both the UK and Continental markets. The UK
is fully competitive and responds well to gas market price signals
at the wholesale level. However, Continental gas markets are not
yet fully open at the retail level and thereby lack the incentive,
as yet, for a fully developed wholesale trading market in gas
which would respond to wider North-West European price signals.
3.4.2 There are also a number of distortions
caused by the continuing strong oil linkage in Continental gas
purchase contracts. When the UK is importing gas, it must pay
a price that at least matches the cost of gas in mainland Europe.
Such imports will often be the marginal gas supply for the UK
market and will therefore set the UK market price. Similarly in
the summer, if UK gas is cheaper than European gas, the European
utilities will continue to buy UK gas until the price discrepancy
is eliminated or there is no more export capacity.
3.4.3. The strategic imperatives of
the major European market players might also be different. For
example, the cold period early in autumn 2003 on the Continent
appeared to put the European utilities' priority on refilling
storage rather than exporting gas to the UK, where prices were
higher. The lack of comparable pricing, for example, to value
gas put into storage properly, means the UK market is being adversely
affected by the failure to liberalise European markets.
3.4.4 With retail markets not fully
open until July 2007, and with full and effective liberalisation
only likely several years after that, this situation could persist
for some time and certainly up until 2010.
3.4.5 The effect that these market
distortions have on UK wholesale gas prices is extremely difficult
to quantify but there is no doubt in Centrica's view that it is
significant.
3.5 Oil prices
3.5.1 Over the last few years, competition
in the UK gas market has led to a decoupling of wholesale gas
prices from oil prices as a result of gas on gas competition.
New gas import contracts secured by Centrica are priced in relation
to UK wholesale gas prices at the National Balancing Point.
3.5.2 However, oil prices still have
an impact on UK gas prices. This follows from Continental gas
prices being oil indexed and the physical pipeline linkage between
Zeebrugge in Belgium and Bacton as explained above.
3.5.3 There is also oil indexation
in a number of older style UK long term gas contracts with producers.
The pricing formulae in some of these contracts mean that the
price of minor oils, including duty, is a significant component
in determining the price of that gas, particularly so at a time
of high oil prices. About one-half of the average change in fuel
oil and gas oil prices feeds through to gas costs in these contracts.
3.6 OFGEM investigation
3.6.1 In its recent investigation into
high wholesale gas prices, OFGEM also concluded that high wholesale
prices were a result of the high oil prices, a tightening of UK
supply and demand and lack of effective EU gas liberalisation.
3.6.2 Two areas of further investigation
were identified, the first pursuing the European market issues
via the European Commission and Member States' regulatory authorities.
Centrica strongly supports this and would urge that this is the
major thrust of further work. The second relates to a small number
of contracts to which Centrica is a party. One of these contracts
is now the focus of a further investigation.
3.6.3 Centrica points out that the
contract concerned is a very particular contract designed specifically
for peak winter use to meet domestic customer demand requirements
in the coldest periods of the winter. Relative to the Continental
European issue the materiality of this second strand of investigation
appears of a different order of magnitude. Centrica has co-operated
fully with OFGEM during its gas probe inquiry and will continue
to do so.
4. Why have electricity prices risen?
4.1 Current high electricity prices have
been largely driven by the worldwide increase in gas, oil and
coal prices. With gas fired generation accounting for 40% of UK
electricity supplies, electricity prices are being affected by
the increases in wholesale gas prices. The following chart shows
how electricity price rises have largely mirrored those in gas
for the contract period from April 2005 to March 2006.
4.2 Electricity prices have also been affected
by a number of environmental costs. The EU Emissions Trading scheme
has increased wholesale power prices for 2005 by 10%, which in
turn would increase retail prices for domestic customers by 4%.
The Renewables Obligation adds approximately 2% to residential
prices in 2004, which is set to rise to 4% by 2010 and 6% in 2015.
5. Impact on domestic consumers
5.1 Whilst Centrica has tried to absorb
some of the wholesale price increases, the size of the increase
has meant that it has been forced to increase its retail prices
to consumers. In August, British Gas announced that it would be
increasing retail prices by 12.4% for gas and 9.4% for electricity.
This is an industry wide issue and other suppliers have generally
followed with similar increases.
5.2 Despite these recent price increases,
UK domestic energy prices are still cheaper than in Continental
Europe where domestic competition has still to be fully implemented.
UK gas prices are approximately 40% less than the European average
whilst electricity prices are 25% less. In real terms, allowing
for inflation, gas bills are still 4% lower than in 1996 and electricity
bills are 3% cheaper.
5.3 Low energy prices have been one of the
key factors in reducing the levels of fuel poverty. The Government
has a target to eliminate fuel poverty amongst the vulnerable
by 2010 and amongst all groups by 2016. Recent Government figures
show that they have largely been on course to do this with a reduction
from 4 million in 1996 to 1.75 million in 2002.
5.4 However, fuel poverty is a complex interaction
of income, housing quality, energy prices and consumption in the
long term. Reductions in the number of fuel poor can not be sustained
by energy prices alone.
5.5 Centrica is sensitive to the effect
that these price changes will have on vulnerable groups and has
introduced a number of measures to mitigate the impact. These
include a £10 million energy trust fund to help people in
debt. British Gas customers can seek financial help not only for
their energy bill debt but also for other household essential
services such as water or telephone. The Fund, which has recently
received Charity Commission approval, will be administered by
independent Trustees and is due to award its first grants later
this month.
5.6 British Gas has also introduced an initiative
offering a three year price cap for pensioners in receipt of pension
credit, which it launched in September in conjunction with its
long term partner, Help the Aged. The "Price Promise"
also includes a free benefits health check, as well as the installation
of energy efficiency measures where these are needed. This is
in addition to a £150 million programme, "here to HELP"
which aims to alleviate household poverty by targeting 500,000
homes with a range of benefits including free energy efficiency
measures and charity support. Currently available only through
local authority referral, British Gas is extending its reach by
allowing the public to refer people to the scheme.
5.7 Increases in income make an important
contribution to lifting people out of fuel poverty. As part of
our fuel poverty programmes, British Gas carry out an assessment
of benefit entitlement. This has revealed that where people are
underclaiming the amount due is around £1,300 per annum.
5.8 Centrica believes there are a number
of initiatives which need to be taken by Government to limit the
impact of high prices. These include:
5.8.1 Inclusion of benefit assessments in
all Fuel Poverty programmes: One of the most effective ways of
removing customers from fuel poverty is to increase their disposable
income. Energy suppliers, through their fuel poverty programmes,
have access to many vulnerable households. By making the benefits
assessment a compulsory element of these programmes, thousands
of households could be assisted.
5.8.2 Extension of Fuel Direct: Current
qualifying criteria for Fuel Direct is just Income Support and
Job Seekers Allowance. Centrica propose that the qualifying criteria
are relaxed to include a wider range of benefits, such as Disability
Living Allowance. Fuel Direct provides an effective mechanism
to those individuals who are less able to take control of household
budgeting. The Department of Work and Pensions (DWP) should also
promote Fuel Direct as a payment option and debt prevention tool
rather than a payment method of last resort.
5.8.3 Improved data sharing/targeting of
fuel poor customers: The targeting of fuel poor customers is extremely
difficult. However there are Government agencies, such as DWP,
who have access to information on those who are on benefits. Centrica
proposes that Government agencies should be encouraged to promote
fuel poverty programmes offered by energy suppliers.
5.8.4 The health sector is also key to targeting
the fuel poor. Primary Care Trusts (on the GP side) and Acute
Trusts (on the hospital side) should be made aware of programmes
and actively encouraged to educate their health sector workers
on fuel poor scheme referrals. This would increase the take-up
of programmes and ensure that help is targeted at those most in
need.
6. Impact on Industrial and Commercial consumers
6.1 Centrica Business Services (CBS) and
Centrica Energy supply both SME and Industrial and Commercial
(I&C) customers with wholesale gas and electricity. Prices
to SME and I&C customers are more closely aligned with patterns
of wholesale prices of gas and electricity. Consequently, these
customers benefit at times when wholesale prices are low but are
adversely impacted when prices are high.
6.2 As the following graph shows, historically
I & C customers have benefited from low prices:
6.3 The volatility and extent of wholesale
gas and electricity price movements during 2004 makes it difficult
to generalise the impact on customers as their individual customer
experiences will vary depending, for example, on the nature of
the contract and its duration.
6.4 Centrica recognise the difficulties
for customers caused by the increase in retail prices during 2004
resulting from the increase in wholesale prices and have acted
to develop innovative contractual arrangements to help businesses
manage their energy procurement.
7. Will we see prices come down over time?
7.1 We would expect there to be downward
pressure on prices but not without some key actions:
7.1.1 Greater transparency in the gas market:
In the short term we believe there needs to be greater transparency
in the offshore gas market where information tends to be non-specific
and only available the following day. This situation contrasts
starkly with that of the UK electricity market where (as a result
of licence obligations) detailed information is available every
half hour on the output of all England and Wales power stations.
7.1.2 We welcome the recent DTI voluntary
disclosure measures on aggregated gas flows into National Transmission
System (NTS). This will help as a starting point for greater transparency
in the UK gas market. However, we have concerns that this does
not go far enough as it includes only "after the day"
production information into the NTS system from beach gas terminals
and storage. Also, this is a voluntary code which does not show
(i) real time flows; (ii) forecast flows; (iii) deliverability,
including specific breakdown of maintenance plans. Finally there
is no requirement to explain why gas is flowing or not.
7.1.3 The introduction of greater transparency
of UKCS gas supply and energy trading information will ensure
an efficient wholesale gas market where prices accurately reflect
the near term supply/demand balance. At Centrica, we have taken
steps to be as open as possible in terms of information disclosure.
7.1.4 Investment in new infrastructure:
As the UK becomes a net importer, significant investment is needed
in new infrastructure projects, including pipelines and LNG terminals
to ship gas from around the world to the UK. In a recent report,
commissioned by British Gas, OXERA estimated that the cost of
investment in new infrastructure to meet the UK's future energy
needs was in the region of £10-£18 billion. Centrica
has agreed long term gas supply deals worth approximately £8
billion with Gasunie and Statoil which have helped underpin the
development of two new pipeline projects to the UK. Most recently,
it has also agreed a major £4 billion contract to import
LNG to the UK which will help underpin the development of a new
LNG terminal. Centrica is also planning to spend a further £4
billion on securing new sources of energy for our customers in
the UK.
7.1.5 Deregulation of European energy market:
It is vital that the UK has a diversity of gas supply from gas
exporting nations as well as a variety of delivery mechanisms
such as LNG and pipelines. Significant amounts of this gas will
come from east of Europe and therefore it is essential that Continental
Europe does not act as a bottleneck to these sources of gas. Recently
we have seen increased consolidation in the European energy market
and decisions by Governments to create national champions. The
vertical nature of these companies and the control they exercise
over their networks are not in the interest of UK or Continental
energy consumers.
7.1.6 The difficulties of access to Continental
gas pipeline networks and other gas facilities prevents efficient
sourcing of gas supplies for the UK. Potentially the issue becomes
more serious as the proportion of imports increases in the UK
gas supply mix. These issues must be resolved not only to prevent
price distortions arising from undue constraints on UK supplies
but also to allow efficient market based remedies in the event
of a supply disruption.
8. What Government/OFGEM can do?
8.1 Current market prices in the UK are
influenced by market distortions arising in Continental Europe.
OFGEM recognised this as part of their inquiry and recommended
more vigorous action through the European Commission. Therefore
liberalisation of the EU energy market is essential. Under the
Gas Directive, domestic markets are due to open in 2007. However,
we believe that this is not going to be fully effective before
2010 at the earliest.
8.2 It is vital that UK Government and OFGEM
place the issue of European energy market liberalisation higher
up their agenda. It is not just about ensuring a level playing
field for UK companies but about securing future supplies for
the UK. Specifically, we would like to see rapid adoption and
implementation of the EU Gas Transmission Regulation in a form
that will have some meaningful effect. The current text of this
regulation could be improved, in particular, parts of the text
appear to seek to protect those very legacy capacity arrangements
that are currently hampering the market. It is also imperative
that the current EU Gas Directive is implemented by Member States
with its requirements that transmission, distribution and storage
operators do not discriminate against third party users of their
network. It is also vital that consumers have the practical ability
to choose their supplier.
8.3 It is also important that EU member
states make greater use of gas and capacity release programmes
which can act as a catalyst in encouraging new entrants. Gas and
capacity release programmes are needed to help reduce undue dominance
by the traditional integrated energy incumbents in the early stages
of market opening.
8.4 Since July 2004, third party access
to Storage should have been implemented on a fair and non-discriminatory
basis throughout the EU. Europe's Gas Storage Operators have still
not agreed how they will do this. Guidelines of Good Practice
for Storage Operators are urgently needed, particularly because
some major Member States have chosen to allow negotiated access
to storage, even though the Storage Operators are providing a
monopoly service in their area. For example, GdF and Total own
all the storage connected to their pipeline system in France and
similar arrangements exist for all the German Transmissions System
Operators and their storage facilities.
8.5 It is important that OFGEM engages vigorously
through the European Regulatory Groups, CEER and ERGEG, to advise
the European Commission and Member States on the implementation
of the Gas and Electricity Directives and the trans-national need
for action. Equally, the UK Government, through the DTI, should
be pushing the case for faster market opening in European energy
markets. With the UK Presidency in the second half of 2005, there
is a good opportunity to put this as a priority item on the agenda.
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