House of Commons - Trade and Industry

Select Committee on Trade and Industry Written Evidence

APPENDIX 7

Memorandum by the Department of Trade and Industry

INTRODUCTION

1. The DTI welcomes the Committee's interest in this important issue, and recognises the valuable contribution of its 2002 Report on Security of Supply. We understand that, although the title of the inquiry is Fuel Prices, the Committee's emphasis is on gas prices, so that is what we will focus on, while also acknowledging their impact on electricity prices.

2. The DTI is committed to improving the competitiveness of the UK economy and to the eradication of fuel poverty amongst vulnerable households and we recognise the significance of higher electricity and gas prices for both these objectives.

NATURE AND EXTENT OF PRICE INCREASES

3. The following chart shows the seasonal fluctuation and average annual trends of spot wholesale gas prices in the UK in recent years.

Chart 1

Source: The Heren Report Notes:Trading data from National Balancing Point (NBP)

This shows that while spot prices have risen this winter, they are in a similar range to peak spot prices over the last four winters (25-30 p/therm) , with the exception of the winter of 2002-03 when they did not exceed 25 p/therm. With rare exceptions, when the Interconnector linking the UK with the Continent has been either full or out of service, these prices are virtually the same as those at the Zeebrugge trading hub in Belgium (see Annex B.1).

4. However, forward prices for Q1 `05 have been high, and higher than those on the Continent, peaking at 68p per therm, although they are now down to an average for the 2 weeks 8-19 November of around 40p/therm.

Chart 2, below shows that forward prices in the UK are currently 20-25% higher than those on the Continent for the next two winters.

Source: The Heren Report

Notes: The data available on prices do not extend beyond contracts delivering in Quarter 2 2006 for the hubs at Zeebrugge (Belgium) and TTF (Dutch) and Quarter 3 2007 for the hub at NBP (UK).

There are a number of reasons why forward prices have increased, including;

— The impact of higher oil prices, to which gas prices are contractually linked in Europe, feeding through to UK prices via the continental link.

— A tightening of the supply/demand balance in the next two winters, as UKCS production continues to decline and as the UK moves towards becoming a net importer of gas. National Grid Transco (NGT) have said that a demand side response would be required if we had an exceptionally cold winter.

— The desire of some large industrial gas consumers to lock in high prices for the winter in order to limit their exposure to a potentially highly volatile spot price

5. OFGEM investigated the reasons for higher gas prices and their report was published on 5 October. They attributed the same main reasons for high gas prices to the first two above. OFGEM are continuing to investigate some aspects of the UK gas market, such as certain older gas supply contracts and maintenance schedules.

HOW IS THIS AFFECTING INDUSTRIAL CONSUMERS AND ARE THEY WORSE OFF THAN COMPETITORS ON THE CONTINENT?

6. The long term trend in industrial fuel prices has been downwards since the 1980s.

Chart 3, below, "Industrial fuel prices in real terms, 1970 to 2003", shows gas prices are more volatile than electricity prices, but both on a downward trend until recently.

Note: Figures for 2004 are not yet available.

And, historically, UK industry has enjoyed amongst the lowest fuel prices in Europe.

Chart 4 below: "Prices in the UK compared to the EU median and prices paid in Germany and France for industrial gas prices", shows UK prices consistently below the EU median since the mid 1990s.

Source: DTI analysis.

Note: Denmark, Luxembourg, Portugal and Sweden have been excluded from this analysis due to lack of available data.

7. The recent increases in spot and forward prices in the UK have meant, however, that, rather than being the lowest in the EU, average large industrial user prices for gas could well be approaching those seen on the Continent. Our best estimate of current industrial prices (including transmission and distribution charges, supplier profit margins and taxes) being negotiated is that UK prices are now on a par with others in Europe, including France and Germany, and are around the EU median.

8. Detailed terms and conditions of individual gas contracts will vary, both in the UK and on the Continent, and are a commercial matter for the companies involved. We would welcome more detailed evidence of prices paid and Continental comparisons. We recognise that some major UK gas consumers seeking contract renewal at a time of very high forward prices will have faced very difficult market conditions. One way for them to get competitive prices is to re-consider the timing and duration of their contracts. They also have a commercial decision to make as to the degree of their exposure to the forward price—purchasing forward locks in a quantity and a price, but the disadvantage is that the price on the day (eg if the winter is not severe) could be much lower than the forward price.

9. The Department is maintaining a dialogue with major industrial consumers to make sure that we understand their perspective, including any evidence of problems in the way that the market functions.

HOW ARE DOMESTIC CONSUMERS AFFECTED?

10. The trend of domestic gas prices has also been downwards over the past 10 years. And UK domestic gas prices have been significantly lower (around 30-40% after tax) than Continental prices in recent years.

Chart 5 below: "Domestic fuel prices in real terms, 1970 to 2004", shows UK gas and electricity prices on a downward trend since the early 1980s until 2004.

Note: 2004 figures are estimated based on announced price rises

11. Latest official data suggests that UK domestic gas prices are still amongst the lowest in the EU (see Annex B.4). Even after recent price announcements, amounting to an 18% price rise over 2004, domestic gas prices in the UK are likely to remain below the EU median. The proportional impact of wholesale price increases on domestic consumers will be less than for industry because the wholesale prices is a smaller component of the whole bill.

12. Many consumers can substantially reduce their energy bills in a number of ways—switching supplier, changing payment method, and becoming more energy efficient. The DTI, together with Ofgem and Energywatch, held a Consumer Event on 22 November to make domestic consumers more aware of how they could save money.

13. The Department takes very seriously the impact of increased domestic prices on fuel poverty. The total number of vulnerable households in fuel poverty in England has declined from 3 million to 1.2 million between 1996 and 2002, a reduction of 1.8 million vulnerable households.

Chart 6 below: "Number of Households in Fuel Poverty 1996-2002", shows the significant decline in the numbers in fuel poor and vulnerable households.

Our best estimate is that, after allowing for the benefits of the Government's fuel poverty measures and rising household incomes, the number of vulnerable households in fuel poverty is likely to increase by about 200,000 over the period 2004 and 2005.

14. The Government remains committed to its target of eradicating fuel poverty amongst vulnerable households by 2010 and is pressing forward with a wide range of measures, such as reduced rate of VAT, Winter Fuel Payments, and the Warm Front, as well as encouraging all householders to seek the most competitive suppliers. Full details were published on 30 November, in Defra's Fuel Poverty Action Plan.

THE GOVERNMENT'S POLICY

15. The 2003 Energy White paper set out the Government's view that competition within a market framework is the best way to deliver its energy policy goals and provide sustainable and reliable energy supplies at affordable prices. Indeed, the UK has been at the vanguard of energy market liberalisation in Europe. We have successfully liberalised the gas and electricity markets in the UK, through the separation of the transport and supply functions, consumers having the right to choose their supplier, and third party access to network infrastructure guaranteed through effective regulation. This has led to increasing competition between suppliers. The September 2004 Report by OXERA[20] concluded that energy markets in the UK were the most competitive in the EU and G7 countries in 2002, and provisionally in 2003.

16. This approach has led to consumer benefits—low prices, more choice of supplier, and reliable supplies, as well as being consistent with the Government's social agenda. The White Paper also placed the environment at the heart of the UK's new energy policy, alongside economic and social considerations, identifying the need to make a significant reduction in carbon emissions as a headline goal. Tackling climate change is the biggest challenge we face today and, clearly, the energy market has a vital role in helping to deliver our aim of a low carbon economy.

17. The manner of delivery of the policy has developed over time—legislative framework, improving regulation and market structure. The basic framework for the market is separation of monopoly infrastructure for competitive functions, subject to independent sectoral economic regulation by the Gas and Electricity Markets Authority (GEMA, which heads Ofgem). GEMA acts under a primary duty to protect the interests of consumers, and has certain powers, concurrently with the Office of Fair Trading (OFT), under general competition law.

18. The Government committed itself in the Energy White paper not to intervene in the energy market "except in extreme circumstances, such as to avert, as a last resort, a potentially serious risk to safety". This policy has made possible the huge programme of private sector investment that is now taking place or planned in infrastructure for bringing gas to the UK market. This programme includes a major new pipeline to bring gas from the Norwegian sector of the North Sea, a new pipeline and enhanced capacity of the existing pipeline to import gas from the Continent, and three new Liquefied Natural Gas terminals (see Annex B.2). It should remove the tightness in the UK winter gas market from the winter of 2006-07.

19. GEMA's policy of de-regulating gas and electricity prices in the UK is consistent with the Government's overall approach. In 2002, GEMA took the view that the domestic gas supply market was sufficiently competitive to allow it to remove the remaining price control on Centrica (which applied to supply to Pre-Payment Meter customers). In general, competitive markets are a more reliable safeguard of the consumer's interest than price controls. Particularly in a volatile market, controls can lead to prices that are unnecessarily high (if a generous controlled price becomes the actual price), or, if too low, can jeopardise supplies. Indeed, an attempt to set electricity prices at uncompetitive levels, through regulation, was one of the major causes of the energy crisis in California in 2001. Competitive markets provide companies with adequate returns, whilst constraining their ability to achieve excessive returns.

CHANGING MARKET STRUCTURE

20. The structure of the gas market has been changing over the last few years as the physical link with the Continent via the Interconnector exposes the UK market to the oil-gas price link. Our market is also being affected by the global LNG market via Europe. Both of these factors will have an increasing impact as gas markets become more international and as UK dependence on imported gas increases. There has also been an increasing connection between gas and electricity prices as the proportion of gas powered electricity generation in the UK has grown.

WHAT ELSE IS GOVERNMENT DOING TO ADDRESS THE PROBLEM?

21. We are addressing any perceived market failure to the extent possible. For example, we and Ofgem are pressing the European Commission to launch a sectoral investigation into any European gas suppliers who may have acted anti-competitively. We are also continuing to press the European Commission hard for liberalisation of energy markets across the EU.

22. UK oil and gas production has passed its peak and will now continue to decline gradually. But it will remain central to UK energy provision for as long as it continues. A significant volume of economically recoverable reserves still remains to be produced, and we are determined to maximise the benefits of those national resources. The Government and industry, working in partnership through PILOT, are pursuing a range of initiatives and policies to ensure that we continue to create the right climate for productive investment, eg the fallow blocks exercise, the new licence approach and the initiative on mature fields.

23. The Government has also set up a voluntary agreement with the oil and gas producers to supply NGT with certain important production information and to make some of this available to the market in aggregated form. Greater transparency on production data will help to reduce uncertainty in the market. We are already receiving valuable information and this is increasing all the time. The agreement needs time to develop if it is to work as intended, rather than resort to regulation, which could result in the producers withdrawing their co-operation.

SPECIFIC CONCERNS OF THE COMMITTEE

Are current GB forward prices a result of market failure?

24. The Ofgem Gas Price Probe did not suggest that market failure was a significant factor in the recent gas price increases, though they have yet to announce whether or not they will launch an official competition investigation into legacy contracts, and the parallel FSA investigation into gas prices in October and November 2003 did not find any evidence of market abuse. The UK energy market has delivered very competitive prices since liberalisation. Some increases are inevitable as the market role is to signal need for additional imports as production from the UKCS declines.

Are current increases a blip or the start of a long-term trend?

25. DTI's base case for gas prices shows them as broadly constant in real terms until 2007-08 and then falling by perhaps 10-20% in real terms by 2010 as new gas import and storage infrastructure comes on stream. However, the future of wholesale gas prices is uncertain and depends on a number of factors, not least the price of oil and the speed of liberalisation in the EU.

Department of Trade and Industry

30 November 2004

Annex A

Background and Analysis

Where are we now?

— What drives the UK Gas Price?

— What is the significance of the Oil-Gas Price Link?

— What have been the Gas Price Movements recently and historically?

— Is there enough gas information available to the market?

What are we doing to influence the future?

— Expansion of Gas Import Infrastructure

— What is happening on Energy market Liberalisation in Europe?