APPENDIX 14
Memorandum by E.ON UK
SUMMARY
The increasing cost of buying gas and electricity
on wholesale spot and contract markets has been the major factor
leading to higher retail prices;
We have developed a range of innovative products
and services to meet the needs of customers who are vulnerable
to price increases;
The main cause of increasing gas prices is the
declining availability of gas on the UKCS in relation to rising
UK gas demand;
We do not expect wholesale gas prices to be
sustained at current levels. The market is responding to high
prices with new LNG and interconnector capacity becoming available
from 2006 to 2007 when the supply/demand balance should ease;
In the longer term, however, we would expect
gas prices to rise again as demand for gas rises, new more expensive
gas reserves have to be exploited and new pipeline infrastructure
has to be constructed;
As it becomes more import dependent, the UK
market will assume more of the characteristics of the continental
market, which imports about 70% of its gas from a small number
of producers outside the EU;
Oil-indexation is likely to remain a component
of continental long term contracts with producers for some time,
but UK gas buyers are likely to prefer to contract for imported
gas indexed to short-term gas prices;
Rising electricity wholesale prices have been
driven by wholesale gas costs and have not yet risen to reflect
a need for new power capacity;
Stability in the regulatory and policy framework
is essential to support new investment in gas and electricity
infrastructure and production;
The Government should consider carefully the
effect on diversity of UK access to fuel sources of implementing
policy measures with other objectives;
Investment in more gas storage in the UK is
needed as the flexibility provided by the UKCS declines;
We would favour the provision of some additional
aggregated information about the physical flow of gas from the
UKCS to improve market confidence, provided this is done in a
way which does not expose the commercial positions of individual
participants.
THE E.ON GROUP
1. This memorandum is submitted by E.ON
UK on behalf of the E.ON Group which is the world's largest investor
owned energy utility. In addition to the UK, the Group has electricity
and gas interests in Germany, Central and Eastern Europe, Italy,
Scandinavia, the United States and Russia.
2. E.ON UK is the UK's second largest retailer
of electricity and gas, selling to residential and small business
customers as Powergen and to larger industrial and commercial
customers as E.ON Energy. We are also the second largest electricity
generator by output and operate Central Networks, the distribution
business covering the east and west midlands. We buy gas for power
generation and for supply to customers, and trade on the UK gas
wholesale market.
3. E.ON Ruhrgas is responsible for E.ON's
Pan-European gas business. It procures gas from sources in Germany
and abroad, including Russia, Norway, the Netherlands and the
UK, and delivers it to gas suppliers, industrial consumers and
power stations in Germany and in other European countries. It
has limited interests in some offshore UK gas fields and a 10%
equity stake in the Bacton-Zeebrugge gas interconnector. It is
also a partner in the new BBL interconnector.
4. E.ON has also signed a memorandum of
understanding with the Russian gas producer Gazprom to work on
joint projects including the North European Gas Pipeline which
will provide an additional route for transport of gas from Russia
to Germany and North West Europe under the Baltic.
ELECTRICITY AND
GAS PRICES
5. The increasing cost to suppliers of buying
gas and electricity on wholesale spot and contract markets has
been the major factor leading to higher retail prices in the UK
over the last year. Wholesale gas costs have risen by 71% and
wholesale electricity costs by 53% since January 2004, although
suppliers may be able to reduce (or "hedge") their exposure
to rising wholesale prices through existing long-term gas purchase
contracts. In setting prices, suppliers have to reach a view on
their forward energy purchase and other supply costs, including
the cost of meeting Government obligations to promote renewable
energy and energy efficiency, and the effect of any price change
on their competitive position within the market. While this may
lead suppliers to come to different decisions, all suppliers have
been obliged to raise their prices over the last year.
6. We have increased our residential electricity
and gas prices by a cumulative amount of 16.4% and 18.5% respectively
during 2004. Despite this increase, our prices are still competitive,
with the average residential customer saving £65 a year compared
to British Gas by taking both gas and electricity from Powergen.
Prices to large industrial consumers have risen more in line with
wholesale energy prices as these account for a higher proportion
of their total cost of supply.
PROVIDING HELP
TO VULNERABLE
CUSTOMERS
7. We are very much aware that our customers
who are on low incomes or who are elderly are vulnerable to increasing
energy prices, particularly if they live in energy inefficient
housing. We have developed a range of innovative products and
services to meet the needs of these customers:
— Powergen Staywarm. Customers
who are over sixty can fix their annual gas and electricity purchase
costs, giving them the assurance that they can use more gas and
electricity if they need to, for example during cold weather,
without having to pay more. We have 350,000 customers on this
tariff.
— Age Concern tariff. This enables
customers over 60 to purchase electricity and gas with a reduced
standing charge for gas and a rebate on the bill if the temperature
falls below 0°C. This product is sold through our partner
Age Concern. We have 90000 customers on this tariff.
— Our prepayment meter tariffs are
amongst the lowest in the country with a significant reduction
in the difference between prepayment meter and standard credit
tariffs since 2000.
— Powergen also manages DEFRA's Warmfront
programme in Eastern England on a not-for-profit basis. Warmfront
is the Government's main programme for funding energy efficiency
measures to tackle fuel poverty.
— Heatstreets. Heatstreets is
an initiative we have developed with local authorities to improve
the energy efficiency of housing on a "street by street"
basis installing energy efficiency measures under our energy efficiency
commitment obligations, and taking advantage of the grants available
under the Warmfront programme for low income households.
— Powergen, like other suppliers, is
subject to the Energy Efficiency Commitment. In the first
two years of the scheme, we had put in place energy saving measures
that could help customers save an estimated £202 million
over the lifetime of the measures. Half of the measures are installed
in the homes of customers in receipt of state benefits, though,
as these customers make no or a limited contribution to the measures,
the proportion of our scheme expenditure on priority customers
is higher, around two-thirds.
8. In addition, we announced a number of
specific measures to reduce the impact on customers of our price
increase in November, which are worth about £8 million in
terms of their cost to our business:
— free cavity wall insulation offered
to all customers aged over 60 and those on income or disability
related benefits. Cavity wall insulation can save each household
around £160 a year on energy bills;
— free benefits entitlement check for
vulnerable customers to ensure householders are claiming all the
Government benefits they are entitled to;
— a halving of the additional charge
for the 400,000 Powergen prepayment electricity customers to an
average of about £4.30 per annum;
— our Age Concern Energy Services customers
will be protected from this price increase until after the winter
months.
HELPING INDUSTRIAL
CONSUMERS
9. Industrial consumers can of course also
be vulnerable to rising energy costs, particularly if these represent
a significant proportion of their total costs and they are subject
to international competition. Many large customers already have
incentives to improve their efficiency of energy use under the
Climate Change Agreement arrangements to reduce their climate
change levy rate. However, we also offer a number of services
to help industrial and commercial customers. For example:
— we provide data services to enable
customers to monitor energy usage and act to reduce consumption
where appropriate. This includes a range of enhanced services
where customers want our advice on energy usage on top of the
data services provision;
— we offer a Triad Alert service to
enable customers to reduce consumption to reduce their NGC Triad
transmission charges where appropriate;
— we provide energy efficiency advice
on request in accordance with our supply licence obligations.
ENERGY EFFICIENCY
10. Investment in measures to improve efficiency
of energy use is the most effective response by consumers to rising
prices as it both reduces the cost of energy now and customers'
exposure to price increases in the longer term and in many cases
is the only measure which can remove a household from fuel poverty.
Energy efficiency is also one of the most cost-effective means
of reducing CO2 emissions. However, in order to use the market
to get a much stronger focus on meeting customers' energy needs
in the most efficient way, Government support is needed, both
to encourage consumer interest in energy efficiency and to provide
funds for the most difficult properties. We are encouraging the
Government to take two specific measures (a) link stamp duty on
house purchases to a house's energy efficiency rating (SAP); (b)
increase support for Warm Front to allow households requiring
more than £1,500 spend on central heating or other relatively
expensive measures to be taken out of fuel poverty.
11. Government and suppliers also need to
work to provide consumers with easier access to high quality advice.
Our Energy Monitor research, conducted by the University
of East Anglia, suggests that consumers actively want to reduce
energy consumption on both cost and environmental grounds but
need stronger financial incentives and better information on how
to do it.
WHY HAVE
ELECTRICITY AND
GAS WHOLESALE
PRICES RISEN?
Gas prices
Tightening UK Gas "fundamentals"
12. In our view the main cause of rising
wholesale gas prices in the UK is the declining availability of
gas on the UKCS in relation to rising UK gas demand.
13. Historically, the UK has produced more
gas than it needs and has been able to export gas to continental
Europe, particularly during the summer. Excess supply has led
to UK gas prices falling during the summer while, during the winter,
as the demand/supply balance has tightened, the ability of UK
gas suppliers to import gas from continental Europe has acted
as a cap on UK wholesale gas prices. This has benefited UK consumers
and UK gas prices have been mostly below European contract levels.
14. However the UK is now moving into a
phase of significant under supply from the UKCS during the winter
period, requiring more gas to be imported than has historically
been the case. However, because the interconnector has limited
capacity in relation to total UK demand, the balance of supply
and demand remains tight, and UK gas prices have risen above European
contract price levels during the winter period.
15. The position has been exacerbated by
a lack of gas storage capacity in the UK. While the UKCS has in
the past been able to provide the flexibility to respond to winter
peak gas demand, this becomes less effective as the UKCS becomes
less able to meet UK demand. With additional storage, gas can
be stored in the summer and made available in the winter when
there are potential shortages. The UK requires more investment
in storage to smooth out the troughs and peaks in UK gas supply
and demand and in market prices. The House of Lords European Union
Committee in its report "Gas: Liberalised Markets and Security
of Supply" (HL Paper 105) drew attention to the relative
lack of storage capacity available in the UK compared to some
continental European countries (paras 97 to 99 and Table 3).
The Influence of the European continental gas market
16. As the UK imports more gas, it becomes
more affected by continental gas market conditions and prices.
Continental Europe is for the most part dependent on imported
gas and the majority of gas bought and sold has been bought on
long term contracts from upstream producers in Russia, Norway,
and Algeria, in addition to indigenous supply from the Netherlands
and smaller volumes from the UK. These contracts, typically indexed
to oil prices, have supported large investments in upstream gas
production and long distance pipelines, in a similar way to the
development of gas production in the North Sea. However this has
recently led to rising continental gas prices as oil prices have
risen, with a lag of between six and nine months, although prices
have not risen as rapidly as they have in the UK.
Other Factors leading to higher UK gas prices
17. Declining UKCS production and the influence
of European gas contracts do not fully account for the prices
actually seen in the market. Gas prices may also have been reflecting
nervousness about the implications of infrastructure or production
failures on the UKCS at times of tight winter gas supply conditions.
WHETHER CURRENT
GAS PRICE
CONDITIONS ARE
TEMPORARY
Balance of Gas Supply and Demand
18. Higher prices and the expected decline
in the availability of gas from the UKCS are stimulating new investment,
albeit with long lead times. We agree with Ofgem's analysis that
the supply/demand balance should ease from around 2006-07 when
significant new import infrastructure is in place. The timing
of major projects and their capacity in relation to UK gas demand
is illustrated at Annex A. The provision of more UK gas storage
capacity will also help reduce the exposure of the UK market to
tight supply conditions during the winter. We are actively supporting
this and are evaluating new storage capacity options in the UK.
19. This may be partly offset by increasing
demand for gas arising from a continued shift to gas for power
generation in the UK and throughout the EU, reflecting the cost
of carbon traded in the EU Emissions Trading scheme (which will
encourage a shift to gas as a lower carbon fuel than coal) and
a need to construct significant new gas-fired capacity to replace
coal and nuclear power plants facing either environmental or economic
constraints.
Assimilation of UK/EU market conditions
20. While the supply/demand balance may
ease, the interrelationship between the UK and continental European
and LNG markets will increase further with market conditions and
prices increasingly affected by market conditions outside the
UK. This will arise because of an increasing requirement for imported
gas, stronger physical connections to the continent through enhancements
to the existing interconnector capacity, the new BBL interconnector,
and UK connection to Norwegian pipelines that can pump gas either
to the UK or continental Europe.
21. The UK market is therefore likely to
assume more of the characteristics of the continental market as
the UK moves from a position of self-sufficiency, relative abundance
of gas and a relatively large number of producers toward one of
import dependence with a smaller number of large producers in
the major gas exporting countries—Russia, Norway, and Algeria—accounting
for the majority of gas supply.
22. LNG will provide an important additional
source of supply but its price and availability may be affected
by demand for LNG in the US, South East Asia and Japan (which,
unlike Europe, do not have the same ready access to imported gas
delivered by pipeline).
Outlook for UK wholesale gas prices
23. The outlook for prices over the next
year or two is difficult to predict and short term wholesale prices
may remain volatile. However, supply availability will improve
from 2006 to 2007 as discussed above, assuming new import capacity
is commissioned in time to compensate for declining UKCS production.
Higher prices may also encourage exploitation of additional UK
gas production. We therefore do not expect UK wholesale gas prices
to be sustained at current levels and to align more closely with
continental prices from around 2006.
24. In the longer term, however, we would
expect gas prices to rise again as (a) demand for gas rises in
response to the EU ETS and similar policy instruments (b) new
more expensive gas reserves have to be exploited (c) new pipeline
infrastructure has to be constructed.
The Future of Long Term Contracts and Indexation
25. Long-term contracts are likely to continue
to play a significant role in the EU gas market. Increasing European
and UK gas demand will require large new investments in gas fields
and infrastructure. The costs of these investments are likely
to be higher either because they are more distant or because field
structures are more difficult (eg Ormen Lange). Higher costs give
rise to higher risks to producers some of whom will seek to offset
these through long-term sales agreements. Purchasers for their
part will not want to buy gas at a price which they cannot sell
on in a competitive downstream market. The indexation arrangements
provide a means of balancing these requirements between producers
and sellers.
26. Ofgem expresses the view that the EU
gas market will become less dependent on oil-indexed long-term
contracts over time, as competition develops further. We believe
that a range of indexation arrangements will develop. Companies
of course have the freedom to agree the contract terms which recognise
their particular industrial and market environment. In the UK,
energy retailers may well want to continue to negotiate gas-indexed
gas contracts, because the UK has a liquid gas market, with a
reliable index, and this ensures that the gas bought is at least
at a similar price to that available to competitors.
27. However, in other parts of Europe, gas
buyers may continue to prefer oil-indexed gas contracts, either
because it offers competitive pricing given market conditions,
or because they wish to avoid the price variability that could
result from indexation to short-term gas prices which could be
affected by short term supply/demand imbalances or any emergence
of co-ordinated behaviour by the limited number of upstream gas
producers. Other forms of indexation are also possible reflecting
market conditions. Indexation to power prices is common in Spain
and Italy and indexation to coal is also used.
28. As liberalisation of the EU market proceeds,
and liquidity improves across Europe, we would expect more gas
indices to emerge and more players to move to gas indexed gas.
Other forms of indexation such as coal may also emerge, but oil-indexation
is likely to remain an important component of long term contracts
with major producers and a continuing, if diminishing, influence
on final prices for some time.
The Effect of Gas Market Liberalisation in the EU
29. Competition in continental gas markets
has been developing since the first EU gas directive was implemented
in 1998 and this will accelerate as the 2003 directive is implemented.
However, the market is already functioning in that large volumes
of gas are being made available to the UK through the interconnector.
In addition, investment in new interconnector capacity and LNG
regasification terminals is proceeding in response to the long-term
supply gap in the UK and high gas prices. The substantial investments
by continental gas companies in UK infrastructure projects does
indicate that cross-border trade, one of the main objectives of
EU gas market liberalisation, is continuing to develop. Certainly
E.ON intends to promote increased cross-border trading across
the European gas market.
ELECTRICITY PRICES
30. Rising electricity wholesale prices
have been largely driven by wholesale gas costs. This is because
increasing gas prices have changed the UK "merit order"
and pushed gas-fired plant to the margin (where they will set
short term wholesale prices) broadly all year, despite the rising
cost of coal on the international market. The spark spread (the
difference between the cost of buying gas and the wholesale electricity
price) for 2005 and 2006 has remained relatively stable suggesting
that power prices have responded simply to rising fuel costs,
rather than to any anticipated capacity shortage.
31. In future, the EU emissions trading
scheme may lead to coal plant operating more frequently at the
margin with coal-fired generation costs having more influence
on wholesale electricity costs. This is already discernible in
forward electricity wholesale costs for 2005. However, environmental
constraints on coal plant will limit the extent to which generators
can switch to coal plant. This may mean that gas plant will continue
to set the price, particularly outside periods of peak demand.
32. From 2007, wholesale electricity prices
may begin to reflect the need for new capacity.
THE WAY
FORWARD
33. Gas and electricity prices are likely
to rise above the levels we have been used to over the last decade,
reflecting the need for new investment in gas and electricity
production capacity and infrastructure, and environmental costs.
However, we believe a number of steps can be taken by Government,
regulators and companies to ensure that UK markets are operating
efficiently and that the UK adopts policies which will help ensure
that it has access to energy at prices that remain competitive:
— stability in the regulatory
and policy framework in the UK and EU will support new investments
in gas and electricity infrastructure and production in response
to high energy prices and emerging shortages;
— the Government should consider
carefully the effect on diversity of UK access to fuel sources
of implementing policy measures with other objectives, assessing
the risks associated with too much dependence on gas. For example,
environmental legislation in the UK should reflect a need to preserve
a continued role for coal-fired generation to help avoid over-reliance
on gas for power generation;
— UK buyers should diversify their
sources of gas, for example through investment in LNG import capacity,
and should also reduce their exposure to volatile short term gas
prices, increasing the role of longer-term contracts of varying
lengths;
— an active UK/EU Governmental
relationship with gas exporting countries such as Russia and the
Caspian states will support investment in new gas production;
— investment in gas storage in
the UK is needed as flexibility provided by UKCS declines and
the UK has much less storage capacity compared to other EU markets;
— E.ON UK would support the provision
of some additional aggregated information about the physical flow
of gas from the UKCS as a means of improving market confidence,
provided this is done in a way which does not expose the commercial
positions of individual participants. This could be achieved,
for example, by releasing aggregated data for major UK terminal
flows, where total flows are above a given level;
— continued liberalisation of
the EU gas market will help UK suppliers secure access to infrastructure
and alternative sources of gas;
— continuing effective Government
action is needed to improve efficiency of energy use to enable
consumers to offset or eliminate the effect of price increases,
whilst at the same time lowering their CO2 emissions;
— delivery of the Government's
fuel poverty target of eliminating fuel poverty for vulnerable
households by 2010 assumes even more importance with rising energy
prices; suppliers and Government must continue to work together
to address the needs of the fuel poor.
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