APPENDIX 13
Memorandum by the Engineering Employees
Federation
INTRODUCTION
1. EEF represents around 6,000 member companies
in engineering and other manufacturing sectors. This includes
the highly energy intensive steel sector through EEF's merger
with the UK Steel Association, through which we also work closely
with the Energy Intensive Users' Group. We also facilitate the
Manufacturing Alliance, which includes trade associations such
as the Chemical Industries Association and the Construction Products
Association, both of whom have substantial number of energy intensive
members. Our evidence draws on all these sources of information.
2. We welcome the decision by the Trade
and Industry Select Committee to conduct an inquiry into rising
energy prices and are pleased to take the opportunity to submit
evidence. Our evidence comprises this submission and the attached
paper from Global Insight.
3. Our key concerns are that:
— Manufacturers are facing significant
increases in energy bills.
— These increases are substantially
larger than those faced by our competitors.
— Higher energy bills have coincided
with a range of other rising costs, which many manufacturers find
difficult to pass on to customers, squeezing profit margins and
hampering competitiveness in export markets.
THE CURRENT
STATE OF
MANUFACTURING
4. Despite the gloomy picture painted by
official data on output, we believe that the situation facing
manufacturing is considerably better than for several years, though
current trends in rising costs raise questions as to whether it
will be sustained into the future.
5. The third quarter EEF Business Trends
Survey recorded the best output and order books trends for seven
and eight years respectively and showed that companies expected
this rate of expansion of continue into the future. More recent
survey evidence from CBI and the Chartered Institute of Purchasing
and Supply suggests that the recovery in manufacturing may have
slowed but that growth remains healthy.
6. Official statistics and survey evidence
also show an increase in investment levels and planned spending
over the next twelve months. This is to be expected at this stage
of the recovery but it is encouraging that the rise in investment
has occurred despite the fact that profitability remains weak
and is not forecast to improve. Anecdotal evidence indicates that
higher investment is being driven by replacement of capital equipment
that had been postponed during the manufacturing recession and
the need to sustain the recent strong growth in productivity in
order to remain competitive.
7. However, if rising costs continue to
squeeze profitability, there must be doubts as to whether the
recovery in investment can be sustained. As chart 1 shows, manufacturing
profitability has recovered since the start of 2003 but the improvement
has been much slower than in the period following the 1990-92
manufacturing recovery when the exchange rate was more favourable
and raw material and energy prices were rising at a slower rate.
Chart 1 Manufacturing sees limited improvement
in profitability
% NET RATE
OF RETURN
ON CAPITAL
EMPLOYED
Source: National Statistics
8. Data from EEF's Business Trends Survey
shows that 17% of companies are able to raise prices for exports
and 16% report that they are still falling despite the range of
cost increases faced by manufacturers. While the latest official
data show producer prices rising by the fastest rate since 1995
at 3.5%, this was dwarfed by the 8.4% rise in input prices. In
addition, the majority of these price rises are concentrated in
a small number of sectors such as recovered secondary raw materials
(56.4%) base metals (20.8%), petroleum products (14.4%) and metal
products (7%). Excluding these the rate of increase in prices
falls to just 1.5%.
9. A useful indicator of the pressure on
margins can be found by comparing the monthly indices for input
and output prices from the Chartered Institute of Purchasing and
Supply. These are shown in chart 2 together with a balance obtained
by deducting the input index from the output index and adding
50. This shows the input price measure at its worst since 1994
and the margins indicator the worst since it was possible to calculate
this in 1999. The margins balance has fallen for four consecutive
months and October saw the largest fall in the history of the
series.
Chart 2 Pressure on margins worsens
INDICES OF
PRICES AND
MARGINS, 50=NO
CHANGE
Source: Chartered Institute of Purchasing
and Supply, Barclays Capital
10. The increase in the cost of electricity
and gas comes at a time when other costs are also rising significantly.
Figures from the International Petroleum Exchange show that the
price of petroleum was 70% higher In October 2004 than a year
previously, while the CRB Reuters index puts metal prices up by
41% over the same period. In addition, a recent EEF survey indicates
that increases in employers' liability premia have moderated but
are still above 30%.
11. This means that is important to look
at expenditure on energy and increases in energy prices in relation
to manufacturing profitability. The evidence presented below highlights
examples where companies report that rising costs of energy and
raw material are threatening to push their balance sheets into
the red. This is at a point in the cycle when profitability should
normally be recovering.
ENERGY COSTS
IN CONTEXT
12. Official statistics show that energy
costs occupy a relatively small share of costs for manufacturing
overall. However, our evidence shows that increases in energy
costs can have a significant impact on balance sheets, in some
cases making the difference between profit and loss. In addition,
energy costs vary significantly from industry to industry. For
example, energy purchases account for 25% of production costs
for steel and paper, 40% for aluminium smelting and 70% for some
industrial gases.
13. Using data from the latest Input-Output
tables (relating to 2002) and the Digest of Energy Statistics,
we estimate that manufacturers spent around £5.55 billion
on energy in 2003, which accounts for just under 3.8% of the total
value added by manufacturing in that year.
14. Given that the concerns currently being
expressed about rising gas and electricity prices, the rest of
our calculations focus on these two energy sources which account
for £4.2 billion or 77% of energy expenditure by manufacturing
in 2003.
15. Energy prices for 2004 and forecast
increases for 2005 were then estimated, using data for wholesale
prices from the Digest of Energy Statistics, Net Back Pricing
gas prices and data on forward market prices for gas and electricity
up to end of 2004 from Heren Energy Analysis Ltd. Though past
experience indicates that forward market will not predict energy
prices with anything like 100% accuracy, they are an important
indicator given that businesses are currently contracting on the
basis of these forward prices.
16. These calculations point to the price
profiles shown in table 1 with a cumulative rise from 2003 to
2005 of more than 50% in gas prices and close to 30% in electricity
prices. Given the evidence reported below of firms, currently
or recently contracting for gas and electricity, reporting price
increases for 2005 on 2004 of at least 30% for both gas and electricity
and often considerably more, we suspect the data shown in table
1 may be underestimating the current increases in energy bills
faced by business.
Table 1 Trends in wholesale gas and electricity
prices, prices in pence per KWh and % change
| Gas price | % change
| Electricity price | % change
|
| 2003 | 7.6 |
| 2.6 | |
| 2004 | 9.7 | 27.9
| 2.8 | 8.8 |
| 2005 | 120.0 | 23.0
| 3.4 | 19.0 |
Source: Digest of Energy Statistics, Heren Energy
Analysis Ltd, EEF Calculations
17. Based on data from the Digest of Energy Statistics
on energy usage by manufacturing, recent and projected growth
in manufacturing output and the price data shown in table 1, table
2 present estimates of manufacturing expenditure on gas and electricity
from 2003 to 2005. These figures should be taken as illustrative
calculations rather than as precise forecasts. For example, official
data may be underestimating manufacturing output, forecast changes
in manufacturing output are likely to be subject to error and
energy efficiency may also have changed over this period.
18. Table 2 suggest expenditure on gas and electricity
will have increased by a cumulative £1.8bn between 2003 and
2005, a rise of close to 43%.
Table 2 Expenditure on electricity and gas 2003-05,
£m
| Gas | Electricity
| Total | Change |
| 2003 | 1289 | 2941
| 4230 | |
| 2004 | 1666 | 3235
| 4902 | 672 |
| 2005 | 2099 | 3937
| 6036 | 1134 |
Source: Digest of Energy Statistics, Heron Energy Analysis
Ltd, EEF calculations
19. The cumulative increase in expenditure on gas and
electricity represents 1.2% of the value added by manufacturing.
More importantly, in 2004 it represents 2.1% of the gross operating
surplus of manufacturing and a cumulative 5.6% by 2005. These
calculations are based on the latest official data for profitability
which relate to 2003. Given that there was only a marginal increase
in net rates of return on capital employed in the first half of
this year and given the cost rises experienced so far it seems
reasonable to assume that the net operating surplus for manufacturing
for 2004 will be little changed from 2003. Some companies may
also be able to pass on cost increases to customers and therefore
avoid the hit on profitability. However, our evidence suggests
that only a minority of companies will be in this position.
20. The rise in energy prices coincide with other significant
cost increases for manufacturing. In particular, the Reuters Index
shows metals prices some 44% above their 2003 on the basis of
the first ten months of this year and up by a cumulative 74% since
2003. While these prices are pretty much a global phenomenon and
therefore do not necessarily contribute to any loss of competitiveness
in the way that differential increases in energy prices do, many
companies face problems in passing them on to customers. They
are therefore accumulating a range of increasing costs that are
extremely difficult to pass on to customers.
21. Input-Output tables show that manufacturing spent
£16.2 billion on steel and non-mineral metals in 2002. In
addition, some manufacturers will face increased costs from the
rising price of metal components. However, we have not included
this in our overall calculations as aside from imports it represents
a flow of money from one part of manufacturing to another.
22. Using the same methodology as for energy prices,
we estimate that the rise in metals prices from 2003 to 2005 will
have accounted for 27% of manufacturing's gross operating surplus.
Taking metals and energy, together, the cumulative increase in
costs is a third of the gross operating surplus.
IMPACT ON
BUSINESSES AND
RESPONSES TAKEN
23. We conclude our submission by highlighting evidence
drawn from surveys of EEF's membership but also those from the
Chemical Industries Association, and the Construct Products Association.
24. Our evidence indicates that the increases in energy
costs are impacting on manufacturers in the following ways:
— Price increases are averaging around 30% for electricity
and are at least 30% for gas. However, the gas price increases
vary substantially depending on the renewal date and the energy
intensity of the sector and can be considerably more than this.
— Both forward markets and the experience of companies
indicate that businesses are facing substantially steeper price
rises than their competitors, also pushing the level of prices
well above those in the rest of Europe. For example, wholesale
gas prices are currently 25% lower in the Continent than in the
UK, while companies in the chemicals industries report being offered
gas contracts starting from next January that are 40% above those
offered in the rest of Europe. Companies in the construction product
industries indicate that current natural gas prices in the UK
are 40% higher than in Germany and France and are expected to
rise by 50% next year, 25% than in Italy and 100% above that in
Italy.
— The rapid and unanticipated rise in gas prices
is causing problems for manufacturers in adjusting to the increase
in prices.
— Related to this are the problems in passing on
costs for firms that are tied to contracts with customers, often
fixed a year ahead. For energy-intensive firms, this can cause
substantial cashflow problems.
— For many companies, there are concerns that they
will not be able to pass on cost increases and that they will
lose competitiveness in export markets. One major international
supplier to the automotive and aerospace sectors saw an increase
in energy bills from 2004 to 2005 of 30% to £7.4 million.
On top of this was increase in expenditure on steel and other
metals of 38% to just under £70 million. Together with other
costs increases such as plastics, this has the potential to wipe
out the profits of the firm's UK operations next year.
— Firms in energy intensive sectors such as steel
and cement are more likely to pass on cost increases. This reflects
both the absolute necessity of doing so and the current strong
demand for their products. Cement manufacturers are suggesting
that prices will rise by 15%, while steel prices are already increasing
by around 70%. This will place a further squeeze on the profitability
of other manufacturers.
— Survey evidence also show that some companies
are unable to absorb rising costs in lower margins points and
are suffering a loss of competitiveness in export markets.
25. Survey evidence and discussions with manufacturers
suggests that they are responding to the rise in energy costs
in the following ways:
— Not surprisingly, firms where energy is a significant
proportion of costs are focusing on measures to increase their
energy efficiency and to reduce their exposure to price rises.
In some cases, though, increased investment in energy efficiency
is diverting resources away from productivity raising investment.
— Firms are making greater use of spot markets,
monthly rolling contracts and day ahead floating price contracts
rather than fixed annual ones. While this is a rational response
to the current price hikes and volatility of gas prices, it means
that firms have to live with more uncertainty, management time
is being diverted into this rather on to more productive uses
and firms are incurring the expense of subscribing to expensive
live data.
— Investment plans are starting to be hit. The squeeze
on profitability is hitting the investment plans of some companies,
In addition, firms with foreign parents in energy intensive sectors
are taking the view that the uncertain cost situation and the
squeeze on profitability means that it is more sensible to invest
outside of the UK. In addition, though it is unlikely to be the
sole factor driving the decision, the steep rise in energy prices
may give the final push to companies considering investing elsewhere
in the world. Evidence from companies surveyed by the CIA suggested
the large increase in relative energy prices was contributing
to the drift of the industry towards the Far East.
ADDRESSING RISING
ENERGY PRICES
26. There is a need for a comprehensive investigation
of the recent behaviour of gas prices, particularly the huge rise
in 2005 Q1 forward prices between April and October this year.
Ofgem's investigation was only able to explain just over half
of the rise, suggesting that the rest might be attributable to
a higher risk premium and market sentiment without offering any
hard evidence.
27. We also believe that there is a need to address the current
fragmented system of regulation with a more seamless one. This
would address current concerns about market transparency and the
effectiveness of regulation.
28. There is a need to accelerate liberalisation of energy
markets in the rest of Europe. Ofgem's analysis suggested that
the lack of competition in European energy markets impacts on
gas prices in Great Britain. In addition, analysis carried out
by Global Insight for EEF suggests that the EU Emissions Trading
Scheme is affecting forward power prices in a differential way
in Great Britain to the rest of Europe, increasing the relative
cost of energy in this country. Only in Great Britain's liberalised
markets are forward markets reflecting the opportunity costs of
trading permits for carbon emissions.
29. UK manufacturers are facing a competitive disadvantage
from rising energy prices. In addition, rising energy prices are
forcing companies to put an increased focus on energy efficiency,
while the EU Emissions Trading Scheme is provoking a shift towards
less carbon-intensive forms of energy generation. The climate
change levy rate should therefore be frozen for 2005, while the
future role of the levy should be examined urgently.
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