APPENDIX 9
Memorandum by the Eastern Shires Purchasing
Organisation (ESPO) (Fuel 2)
The Eastern Shires Purchasing Organisation (ESPO)
is a purchasing and distribution consortium of local authorities
operating under the Local Authorities (Goods and Services) Act.
[21]In
addition to its seven member authorities, ESPO also manages energy
procurement on behalf of other local authorities, public and charitable
sector organisations amounting to total annual expenditure of
some £40 million at approximately 4,500 sites located primarily
in the Midlands and east of England. [22]
The recent increases in gas and electricity
costs are having a significant impact on the local authorities,
schools, charities and other organisations on whose behalf we
procure energy. ESPO therefore welcomes the opportunity to submit
its comments to the inquiry into the effects of the recent increases
in gas and electricity price on both domestic and industrial/commercial
customers.
1. The EU gas market is primarily indexed
to oil derivatives, to which the UK is linked via inter-connector,
so EU gas prices set a reference price for the UK—whilst
there is a lagging effect of between three and six months, this
is not always apparent or evident when increases in oil prices
are cited as the reason for gas price increases.
2. Oil prices have risen 30% since January
2004, but notwithstanding the supposed link between gas and oil
prices, gas prices have risen by more than 60% in the UK, against
a corresponding increase in continental prices of 26%.
3. In the past two years the UK wholesale
cost of gas has MORE THAN DOUBLED.
4. Gas producers have seen massive increase
in profits this year—although it costs just as much now
to extract gas as it did a year ago.
5. ESPOs clients have faced increases of
up to 50% this year in their gas and electricity costs, and those
currently midway through two year fixed price contracts face increases
of up to 60% in the next financial year if current market prices
are sustained. This threatens public services, including local
authority energy efficiency programmes and will have a significant
impact on the educational sector in particular, with a number
of schools already considering cuts in teaching posts.
6. In real terms this equates to an increase
of £5 million this year in the cost of gas and electricity
to schools, local authorities and charities served by the ESPO
consortium, and further increases are likely if current market
prices are sustained and as contracts become due for renewal.
7. Energywatch has estimated 500,000 more
domestic consumers face fuel poverty as a result of the increases
in domestic energy prices of up to 20% in the last year.
8. Ofgem has just completed and reported
on a year long investigation into gas price increases that occurred
in October and November 2003. The Regulator found no evidence
of market manipulation within the terms of reference of its
investigation, but identified rising oil prices and declining
UK gas as the principal reasons for the increases, although further
issues relating to the release of gas to the UK markets has been
referred to the EU Competition authorities for further investigation.
9. Ofgem's investigations into more recent
market behaviour are understood to be continuing.
10. Whilst the investigation undertaken
by Ofgem was undoubtedly thorough, within the terms of their
remit, they have failed to establish clear reasons for current
market behaviour. We are concerned that Ofgem only has responsibility
for the onshore markets and has no jurisdiction over the offshore
sector or activities in other European states—suggesting
any investigation into market prices undertaken by Ofgem cannot
be as comprehensive as it should be.
11. The main price drivers most frequently
cited by market commentators such as Heren and Spectron, and given
by suppliers, are predominantly related to offshore events such
as planned and unplanned maintenance and production outages affecting
supply, compared to onshore events such as the weather influencing
demand.
12. The offshore gas licencing regime does
not provide for disclosure of vital market information and this
undoubtedly hinders the effectiveness of the market. At present
the regulation of the onshore and offshore markets is undertaken
by separate bodies, and there is a case for combining regulatory
responsibility for offshore with onshore within a single body.
13. Ofgem referred some issues relating
to trading to the Financial Services Authority. Even though its
investigation found no evidence of malpractice, we understand
the FSA has written to all energy trading companies warning that
unless they comply with the trading rules, it will impose a tighter
regulatory framework in future.
14. The markets' reaction to the Ofgem and
FSA reports was a further dramatic leap in prices, with wholesale
gas for January 2005 increasing by 11% on the day the reports
were published, and a similar increase for electricity. The report
was seen by many traders as a "green light" and by energy
consumers, facing increases of up to 60% compared with a year
ago, as more bad news.
15. Ofgem concluded in its report that the
high level of prices was likely to be sustained for another two
to three years before the impact of additional inter-connector
capacity and an increase in Liquid Natural Gas import and storage
facilities becomes available.
16. Since the inter-connector link between
Bacton and Zeebrugge became operational, producers had the opportunity
to export gas to Europe when European prices were higher than
in the UK, and to switch to import mode when prices here were
higher. It is notable that on a number of occasions the interconnector
has not changed the direction of the gas flow, continuing to export
to Europe, even during periods when UK prices were higher than
in Europe—helping to maintain high prices in the UK.
17. The gas and electricity markets have
been modelled on markets for other traded commodities. However,
whilst there is perhaps no difference in economic or purely trading
terms between the various commodities, there is a significant
difference between say, gas and electricity, and other commodities
in that at the point of consumption the consumer is captive
with no realistic alternatives, whilst the parties involved in
trading have no interest in what happens further down the supply
chain.
18. The On-the-day-Commodity (OCM) markets
for gas and electricity drive retail—or consumer contract—prices.
19. All suppliers use the same resulting
price "curves" so there is negligible difference in
terms of the energy content of quotations between suppliers.
20. The OCM markets account for a very small
proportion of the total energy being traded. For example, between
September and November 2003 OCM gas trades accounted for 672 to
772 mcm per month, compared to 51,115 to 56,789 mcm nominated
to Transco (ie physically supplied) for the same periods—or
just 1.3 to 1.5% of total volume. [23]
21. Furthermore, greater volumes are traded
for "short delivery" with smaller volumes traded for
future periods. [24]
22. As a consequence, the wholesale markets
are "illiquid" which means the price can be set by relatively
minor trades for small volumes, in particular for future periods.
This is borne out by the difficulties Industrial and Commercial
purchasers encounter when seeking to negotiate contracts of more
than a one year duration.
23. The prices "established" through
the OCM markets—irrespective of whether any trading has
taken place at those prices—may bear no relation to the
true value of the energy being traded and yet have a considerable
influence on what is regarded as the "market price".
In effect, the "marginal price" has become the "market
price"—and retail sellers will set their prices accordingly,
irrespective of where the energy they are selling has come from
and how much it cost them.
24. Conversely, the majority of trading
transactions are undertaken bi-laterally directly between the
trading partners and are not reported (Gaz de France estimates
that about 85% of gas sold at beach terminals—to suppliers,
downstream subsidiaries of producers etc—is still sold via
long term contracts).
25. We understand this is different to the
system in the United States, where all trades must be reported
and the penalties for failing to do so, or for misreporting, are
severe.
26. This leads us to conclude that even
if there is no market manipulation, there is, at the very least,
undue influence being exerted by relatively small volume transactions
on the OCM markets
27. Ofgem also concluded that as the energy
markets throughout Europe are de-regulated, this will help in
increasing competition and pricing. This may prove to be the case
but appears to be somewhat at odds with the current situation—a
fully deregulated UK energy market in which prices are significantly
higher than corresponding prices in the "less competitive",
illiberal European markets.
28. In a written reply to Alan Duncan MP
the former Energy Minister, Stephen Timms, asserted that "Britain's
generation market is now amongst the most competitive in Europe".
This may be true in terms of the number of generators, but it
is not reflected in terms of the retail price of electricity
to Industrial and Commercial consumers. [25]
29. The number of gas and electricity suppliers
has been shrinking in recent years through failures, mergers and
acquisitions, and this has resulted in a limited number of dominant
pan-european vertically integrated energy companies—the
same dominant companies that currently supply the rest of Europe.
30. Increasing price volatility has rendered
conventional methods of tendering obsolete but, even using the
latest e-procurement technology and techniques, it has been increasingly
difficult to obtain prices as on several occasions in recent months
suppliers have submitted and withdrawn bids up to three times
within a single day—which does not include additional prices
provided to the suppliers' sales teams that were withdrawn before
they were submitted to the customer.
31. The number of suppliers submitting bids
for contracts has been steadily falling in recent years, reflecting
the reduction in the supply base through failures, mergers and
acquisitions.
32. This has been exacerbated by market
segmentation and some suppliers deciding to leave specific market
segments—a particular problem for multi-site organisations.
33. As a result suppliers are able to "cherry
pick" and are increasingly selective about the business for
which they submit bids. Although ESPO has had some success in
maintaining a relatively healthy response to Requests for Quotation,
a "good" response has fallen to around three to five
bids now compared to six to seven only two years ago, although
on one occasion this year we were only able to secure a single
quotation.
34. A number of organisations report they
are having difficulty obtaining tenders and that on several occasions
only the incumbent supplier has submitted a quotation—it
would also appear that smaller customers are being ignored by
most suppliers as evidenced by the number of smaller organisations,
in particular District Councils, approaching ESPO for assistance.
35. Whilst not directly related to the issue
of pricing in the context of this inquiry, suppliers' standards
of service in terms of supply point administration (managing transfers
of supply points between suppliers), timeliness, clarity and accuracy
of billing, provision of meter readings, and general responsiveness
remains very poor. In many instances suppliers fail to achieve
even a basic standard—at a time when significant profits
are being reported by the vertically integrated energy companies.
Whilst the UK markets have been deregulated
to a greater extent than the majority of other European markets,
suggestions that greater liberalisation will provide the answer
appear to fly in the face of the simple fact that UK prices are
now higher than those in Europe, despite the UK market being "competitive".
To summarise:
— Number of suppliers has reduced—active
competition limited—and suppliers cherry picking—but
service remains poor.
— Due to the nature of the product,
consumers are captive.
— In any event suppliers are all
pricing against the same price curve, derived from the OCM markets,
which drive retail contract prices.
— The OCM markets represent less
than 2% of the total volume of gas being supplied.
— The bulk of volumes traded bilaterally,
are not reported—the bulk of the gas coming ashore is sold
to suppliers and downstream subsidiaries of producers on long
term contracts.
— Consequently relatively minor
transactions establish the "market price", which bears
no relation to the true cost of energy and provides scope for
undue influence to be exerted on the market by relatively minor
transactions.
— The offshore gas licencing regime
does not provide for disclosure of vital market information.
— Regulatory responsibility for
offshore and onshore should be combined within a single body.
We trust our comments and observations assist
the Committee in its inquiry and look forward to the publication
of the Committee's conclusions.
Ken May
Director
22 November 2004
21 ESPO's member authorities are the County Councils
of Leicestershire, Lincolnshire, Cambridgeshire, Norfolk, Warwickshire
and the City Councils of Leicester and Peterborough. Back
22
ESPO also provides energy procurement services to a number of
other authorities for example; Lincoln City and Norwich City,
the District Councils of Fenland, South Cambridgeshire, Kings
Lynn & West Norfolk, Charnwood, as well as schools, colleges,
Housing Associations and charitable organisations. Back
23
Source: Ofgem. Back
24
Source: Joint Energy Security of Supply Working Group,
JESS, May 2004. Back
25
Letter dated 1 September 2004 in response to letter to the Minister
of 17 August sent on behalf of a constituent and member of the
Major Energy Users' Council. Back
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