APPENDIX 19
Memorandum by INEOS Chlor Ltd, INEOS Fluor
Ltd and European Vinyls Corporation
CONTENTS
1. Executive summary
2. Rising prices of wholesale gas in the UK
3. The effects of high gas prices on INEOS and
EVC
4. The effects of high gas prices on the UK
economy
5. The OFGEM investigation: Probe Into Gas Prices
6. What is wrong with the UK gas market?
7. Short term recommendations to correct the
UK gas market
8. Recommendations for a competitive European
market
Annex 1—Comparison of UK and European
Wholesale Gas Prices
Annex 2—Price Trends: Delivered Gas in
Continental Europe
Annex 3—Gas Export Data (Source DTI)
Annex 4—Comparison of UK and German Electricity
Prices
Annex 5—Background to INEOS and EVC
Annex 6—The Wholesale Gas Market
1. EXECUTIVE
SUMMARY
1.1 INEOS Chlor Limited, INEOS Fluor Limited
and European Vinyls Corporation (EVC) are major chemical companies
operating throughout Europe. We are able to provide evidence on
behalf of all three companies based on extensive and comprehensive
knowledge of the gas and electricity markets in which the companies
operate. Our evidence is based on first hand experience and demonstrates
that the UK gas market is failing to deliver competitively priced
energy to UK industrial consumers.
1.2 INEOS Chlor is based in Runcorn, Cheshire
where we produce 80% of the UK's chlorine and caustic soda. The
manufacture of chlorine is energy intensive. We purchase approximately
250 million therms of natural gas per year, which is used to produce
electricity.
1.3 INEOS Fluor and European Vinyls Corporation
Ltd (EVC) are part of the INEOS group of companies and also operate
from the site in Runcorn. These businesses are not as energy intensive
but are dependent on the chemicals produced by INEOS Chlor.
1.4 Our main concerns are:
— Industrial consumers, such as us
and other energy intensive users, are particularly impacted by
wholesale gas prices.
— Gas prices in the UK wholesale forward
market have rapidly become extremely uncompetitive in comparison
to Continental Europe. Cost increases cannot be passed on to
our customers or our products will be procured elsewhere.
— It is essential for businesses to
be able to purchase competitive energy for future delivery in
order to manage risk. This is currently impossible in the UK.
We sell a significant proportion of our product at prices agreed
ahead of time; we therefore require the ability to purchase gas
in a similar way.
1.5 As industrial consumers, we require a "level
playing field". We believe wholeheartedly in the principle
of a free market but also believe that the UK gas market has become
uncompetitive. The actual price of wholesale gas is less of an
issue; it is the growing differential with Continental Europe
that will make our businesses uncompetitive.
1.6 It is our view that the forward wholesale
market is currently "broken". Very urgent action is
required to correct this very serious threat to UK competitiveness.
1.7 We believe that this situation is being
primarily driven by a distortion in the supply/demand balance
in the forward market. This is being caused by a trend by gas
producers to withdraw from "supplying" gas in to that
market for a number of reasons.
1.8 Our evidence sets out some of these reasons.
We have also given our views on the actions required both in the
short and medium term to ensure that a properly functioning and
competitive market is restored in the UK, to meet the long term
interests of UK manufacturing.
1.9 In particular we would recommend the following
short term actions:
— Suppliers should be required to make
available the same pricing structure in the UK as in Continental
Europe.
— The reasons for producers abandoning
the forward market should be examined and changes made to encourage
participation.
— Short-term controls should be placed
on the use of the Interconnector.
2. RISING PRICES
OF WHOLESALE
GAS IN
THE UK
2.1 The UK forward gas price has more than doubled
in the past two years. In the same period, the wholesale gas price
in Continental Europe has not risen to the same extent with the
result that the UK forward gas price is now much more expensive
than the equivalent Continental European price. In October 2004,
UK forward wholesale gas prices were more than 40% higher than
Continental Europe (Annex 1).
2.2 Our experience of purchasing gas in several
European countries enables us to make direct comparisons of gas
prices across Europe. In Annex 2 we have shown the changes in
the price of delivered gas from 2003 to 2005. We have shown these
alongside the prices we would have paid in the UK for equivalent
contract arrangements at similar size sites.
2.3 The simple explanation given for rising
gas prices is a combination of dwindling UK reserves, a move towards
the UK becoming a net importer of gas and rising crude oil prices.
This position has been officially put forward by the DTI in written
responses to INEOS Chlor, in response to Parliamentary Questions
and has often been reported in these most basic terms in the general
media. However, these are not the key reasons and we would point
out:
— The UK remains a net exporter of
gas. DTI data shows the UK has been a net exporter of gas since
the Interconnector to Zeebrugge opened in 1998 with record exports
in 2003. (Annex 3).
— Even when the UK is a net importer
of gas, the UK will source all of its gas from geographically
local sources in contrast to the rest of Europe. At worst UK prices
should only be as high as prices in Continental Europe.
— Continental European gas prices are
linked to oil and this has caused only moderate increases in continental
prices over the past two years. During the same period UK forward
gas prices have almost doubled.
2.4 Given our knowledge of European Gas prices
and our significant consumption, we have tried to purchase non-UK
gas for delivery to our UK Sites. It has proved extremely difficult,
and in most cases impossible, for us as a consumer to overcome
a large number of logistical and commercial obstacles in order
to bring non-UK gas into the UK system for our consumption. Where
we have managed to solve the logistical issues, we have discovered
that the commercial offers end up with a price delivered to our
site in the UK, which is no better than the general UK market
price, even though the price for the same gas on the Continent
is considerably lower.
2.5 OFGEM and the UK Offshore Operators Association
(UKOOA) have stated that there is a need for high gas prices in
order to encourage investment in new sources of supply and infrastructure.
Major gas producers have told us that a gas price of 20 ppt is
all that is required to justify such investment and yet the prices
currently quoted for supply in 2005 is almost double this figure.
This is supported by economic studies by Wood Mackenzie.
2.6 From our experience of the European energy
markets it is clear to us that the UK gas market is now failing
to deliver competitively priced energy versus Continental Europe.
3. THE EFFECTS
OF HIGH
GAS PRICES
ON INEOS AND
EVC
3.1 INEOS Chlor requires competitively priced
energy. Our concern is less about the fact that prices have risen
and more that the UK forward gas market has become much less competitive
than Continental Europe. We need a level playing field in comparison
to Continental Europe.
3.2 We operate in a highly competitive commodity
European chemical market.
3.3 We are unable to manage fundamental
business risk. As commodity chemical producers, we typically sell
a significant proportion of our production at prices agreed ahead
of time. As such, we require the ability to purchase the materials
required to make these products in order that we can manage the
business risk. Given the high price differentials between the
UK and Continental Europe we are prevented from doing this—the
price differentials we have seen would have broadly wiped out
our profits. Instead we are faced with the only alternative, to
"take a bet" that the "spot" price on the
day will be lower and competitive with prices in Continental Europe.
3.4 In the event that prices on the prompt
or "spot" market are also uncompetitive then we would
be faced with difficult choices in order to minimise the impact.
These include:
— Passing price increases through to
customers. However, it is generally not possible to pass on price
increases or our products (and our customers' products) will be
sourced elsewhere in Europe.
— Seeking to reduce our production
volumes such that we only produce products which generate margin.
— In the case of EVC, because we operate
plants making the same products in different countries, transferring
production from the UK to Germany or Italy.
— Reducing other costs, in particular
through lowering fixed costs and/or reducing business investment.
4. THE EFFECTS
OF HIGH
GAS PRICES
ON THE
UK ECONOMY
4.1 The Chemical Industry is of central
importance to UK manufacturing industry, accounting for about
11% of manufacturing gross output, and about 230,000 jobs. The
chlor-alkali sector in turn is of central importance to the Chemical
Industry.
4.2 If the INEOS Chlor business were to
close there would be immediate impact on 10,000 jobs in UK chemicals
(4% of the sector) with longer-term loss of 19% of chemical manufacturing
jobs in the UK. Industry revenue losses are estimated to reach
about £8 billion per year over that period.
(Source—LECG evaluation of options
for Runcorn (Sept 2001).
4.3 The rising gas price also has a direct
impact on the cost of electricity in the UK. A marked price differential
has opened up between the UK and Continental European wholesale
electricity prices (Annex 4). This has an impact on our businesses
and on our customers in the UK.
4.4 The increase in gas prices will make
power generation by other fuels more attractive. As a result a
degree of fuel switching will take place (to coal and oils), which
will result in higher levels of CO2 emissions. This is in direct
conflict with the Government's four guiding principles set out
in the Energy White Paper.
5. THE OFGEM
INVESTIGATION: PROBE
INTO GAS
PRICES
5.1 INEOS Chlor was disappointed with the
OFGEM report into rising wholesale gas prices that was published
on 5 October 2004. Whilst we endorse some of the major findings
in the body of the report, we believe that the summary of the
report was misleading as it put the wrong emphasis on the causes
of price increases, most of which remain unexplained.
5.2 The interim report issued in May 2004,
focused on increases in the prompt (spot price) market during
Q4 2003. While the final report in October 2004 did consider the
futures market it is our view that this was not treated as central
to the investigation. Further, we note there are a number of areas
of investigation, which have not been fully concluded.
5.3 OFGEM states that in their opinion rising
oil prices only account for around 30% of the increase in gas
price for Q1 2005. Around 50% of the increase seen at the time
the report could only be explained as "market sentiment".
5.4 We do not accept, and the report does
not conclude, that the most significant reason for the increasing
UK gas prices is as a result of increasing oil prices. It is unfortunate
therefore that graphs used in the report have been used to illustrate
a simplistic, linear correlation between rising crude oil prices
and those in the forward gas market.
5.5 We welcome that the report highlighted
concerns at the lack of competition in the Continental European
market and the possibility that contractually available gas may
not have been released to the UK market. We share these concerns
and believe that there are specific issues created when two markets
operate side by side with different levels of liberalisation.
6. WHAT IS
WRONG WITH
THE UK GAS
MARKET?
6.1 It is our view that the UK's forward
gas market is "broken". The structure and operation
of the market is failing the UK's intensive industrial users.
The UK remains a net exporter of gas to Continental Europe. It
is therefore, in our view, inexplicable for wholesale prices to
be higher in the UK than are available to industrial consumers
within the EU. A properly functioning forward market is essential
for a "UK type" gas market to work.
6.2 Major gas producers have told us that
they are increasingly reluctant to sell their gas in the forward
market. This creates a supply shortfall in the forward market,
which drives up prices. The reasons given by producers for this
change of behaviour are:
— They are less willing to sell forward
in case they have production problems. They see any forward selling
as a potential risk. They do not see a need to sell forward as
they are confident they can sell their production output in the
very short-term markets if required.
— Major gas producers now measure themselves
at Stock Market level against their global peers who do not sell
forward.
— The current tax regime on gas production
is based on prompt prices and this encourages producers to sell
into this market rather than sell forward.
6.3 Producers and consumers do not have
equal access to market sensitive information within the wholesale
gas market. This view has recently been made by amongst others
British Gas and undermines the view that the UK gas market is
truly competitive as the current structure operates to the detriment
of consumers.
6.4 We have also heard comments in Continental
Europe that would suggest the problems with the UK forward market
are a good reason for resisting change to the continental markets.
It is hard to imagine how the current situation acts as an incentive
for European governments to accept the type of market reforms
that the UK administration is pushing within the EU.
6.5 We believe there are issues with the
regulation of the UK market. There seem to be a number of agencies
(DTI, OFGEM, FSA) leading to a fragmented regulatory structure,
which is far from clear to gas consumers.
7. SHORT TERM
RECOMMENDATIONS TO
CORRECT THE
UK GAS MARKET
7.1 As previously noted, our main concern
is that the UK forward market is failing to deliver competitive
pricing. We are seeking action to correct this so that we can
compete on a level playing field within the chemicals market.
7.2 While Europe moves towards an open and
competitive market we believe short-term action is required to
correct the immediate issues with operation of the UK market.
7.3 Suppliers should be required to make
available the same contracts to UK consumers as those available
to customers in Continental Europe.
7.4 Action should be taken to encourage
participation in the forward markets. The reasons that producers
give for abandoning the forward market should be examined and
if necessary changes made to encourage their participation.
7.5 There should be immediate controls on
use of the Interconnector. These might include:
— Restricting exports through the Interconnector
such that in any year exports should not be allowed to exceed
imports.
— Making a part of the Interconnector
available to consumers at a reasonable price so that we would
be able to source European gas and deliver it to the UK.
8. RECOMMENDATIONS
FOR A
COMPETITIVE EUROPEAN
MARKET
8.1 We fundamentally believe in free markets
but there are a number of improvements that need to be addressed
in order to make the gas market function properly.
8.2 Further action is required to ensure
there are equal levels of liberalisation in Continental Europe
and the UK.
8.3 For the market to function competitively,
equal information must be made available to all participants.
The new information recently made available does not go far enough
and we note the ongoing efforts of Energywatch in this regard.
Information asymmetry is a well-known cause of market failure
in traded markets.
8.4 There needs to be unitary regulation
of the gas market from wellhead to supply point.
8.5 Efforts should be made to encourage
new supplies of gas to the UK.
8.6 Investment in additional storage capacity
should be encouraged so as to make the costs of storage competitive.
It would appear that storage operators have been able to substantially
increase revenues from sale of storage due to the relative scarcity
of storage capacity in the UK.
Annex 1
COMPARISON OF UK AND EUROPEAN WHOLESALE GAS
PRICES
Annex 2
PRICE TRENDS: DELIVERED GAS FROM CONTINENTAL
EUROPE
A comparison of the future prices of wholesale
delivered gas from Italy and Germany and equivalent contract arrangement
in the UK. This data excludes taxes:
Annex 3
GAS EXPORT DATA (SOURCE DTI)
Annex 4
COMPARISON OF UK AND GERMAN ELECTRICITY PRICES
Annex 5
BACKGROUND TO INEOS AND EVC
INEOS Chlor is based in Runcorn, Cheshire where
we produce 80% of the UK's chlorine and caustic soda. These products
are vital building blocks in the production of most chemicals
made in the UK. Chlorine is used to purify 98% of our national
water consumption, to produce 96% of crop protection products
and 85% of pharmaceuticals. It is also a major raw material for
the manufacture of plastics. Caustic is used in every major chemical
production process and is essential to a wide range of everyday
products including soap, cosmetics, clothes, antiseptics and cleaning
products. INEOS Chlor has around 1,400 direct employees based
in Cheshire.
The manufacture of chlorine is energy intensive.
INEOS Chlor purchases energy in the form of natural gas, which
is used to produce electricity for use in the chlorine production
process (electrolysis of brine).
INEOS Chlor purchases around 250 million therms
per year of natural gas for use in the Runcorn manufacturing activities.
As such we understand we are probably in the top three of industrial
consumers (by volume) in the UK, outside the power generation
sector. Natural gas represents some 60% of the total business
variable production costs. Every penny added to the wholesale
cost of gas increases our production costs by some £2.5 million.
INEOS Fluor and European Vinyls Corporation
Ltd (EVC), which are both part of the INEOS group of companies,
also have operations within the same site at Runcorn. While these
businesses are not as energy intensive as INEOS Chlor, energy
is a significant cost. More importantly, these businesses are
extremely dependent on the chemicals produced by INEOS Chlor.
Runcorn site is the home of a number of other companies including
APL, BOC and High Chemicals that again are dependent on the chemicals
produced by INEOS Chlor.
INEOS Chlor and EVC also have manufacturing
assets located in France, Germany and Italy as well as several
smaller UK sites. The various sites consume significant amounts
of energy in the form of both natural gas and electricity.
Annex 6
THE WHOLESALE GAS MARKET
The delivered price of gas to consumers is a
combination of the wholesale price and the cost of delivering
the gas. As industrial consumers our price depends very largely
on the wholesale price of the gas (the commodity price).
Wholesale gas can be bought in the UK market
through "Forward" contracts or in the "spot"
market where the price is determined every day. Typically industrial
customers will buy gas with a mixture of contracts, using forward
contracts to manage price risk and "spot" contracts
to reduce costs, as these are traditionally around one penny per
therm (ppt) cheaper.
Our particular concern is with the operation
of the UK "forward" gas market. It is essential that
we make like for like comparisons between markets and comparing
wholesale gas prices across European markets best does this. For
example delivered prices are very easily distorted by delivery
costs, which vary with the size and location of the consuming
site. In particular, domestic prices in the UK may still look
quite competitive relative to prices in Continental Europe, but
this is because higher wholesale prices are hidden by lower transportation
costs in the UK.
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