Examination of Witnesses (Questions 42-59)
ENERGY INTENSIVE
USERS GROUP
25 JANUARY 2005
Q42 Chairman: Good morning. Could you
introduce your colleagues, and then we will get started.
Mr Farrell: Yes. I am Kevin Farrell
and I am Chairman of the Energy Intensive Users Group. This is
Jeremy Nicholson, the Director of the Energy Intensive Users Group,
and this is Dr Jim Robertson, the Energy Director, Terra Nitrogen
UK Limited, but he also has various European connections and chairs
committees in Europe about the whole issue of gas prices.
Q43 Chairman: We sometimes lump industrial
and commercial customers together as a homogenous group. Are there
significant differences between the problems faced by the different
sectors, or between large and small companies within each sector,
in dealing with energy price rises? Is there a uniform problem
with a uniform response?
Mr Farrell: No. The whole reason
for the Energy Intensive Users Group is to provide a lobbying
base for those industries for whom energy content is both a very
large and a very unpredictable part of their costs and often over
which they have no control. As you go down the scale, people or
other companies, it is either a lower proportion or the size of
their consumption gives them lesser options. We are at the heavy
end and companies must decide both how they buy and how they take
the risk and how far forward.
Mr Robertson: I think there is
one important difference, which certainly in the first session
did not emerge, and that is that the delivered price of gas is
essentially made up of three items: the wholesale price; the transportation
cost; and other administrative costs and margins. The difference
between intensive energy companies and smaller users is that the
transportation costs are not nearly such a significant effect.
One of the great achievements of liberalisation of gas in the
UK was to control transportation costs. Because transportation
costs in the UK have been well regulated and well controlled,
smaller users, commercial users who have a relatively high proportion
of transportation costs, see a relative advantage. That is one
of the reasons, when you look at statistics, that you see domestic
and commercial prices have been, in the '90s, ahead of the rest
of Europe, and the advantage to big industrial companies has not
been nearly as big—although from time to time there has
been a small advantage.
Q44 Chairman: We got the impression,
I think, from evidence that was submitted in October time, that
forward gas prices were very high in September, when many companies
were agreeing their new supply contracts, and prices have since
fallen quite significantly. But many of those who sent us written
evidence were the people who agreed to take on contracts at the
most expensive time. It seems a bit daft to buy energy at the
most expensive time. Did they have a choice? Maybe you could explain
for the record how you, as customers, operate in this market.
Mr Farrell: I can answer it as
far as ceramics and some others are concerned, although people's
policies differ. You actually buy—and it is a fairly brutal
regime—when your price contract runs out, and there are
some quite severe penalty charges, so you cannot go shopping in
a conventional sense. We actually took a view inside our industry
many years ago to stay outside the September period. Really, where
you would get indicators that the price would be likely to be
higher in the winter, almost automatically, we advised companies
five or six years ago or more to attempt always to negotiate May
to August. That is beneficial. I do not think it is a material
influence. If you normally negotiate in September, you might pay
a marginally higher price, but then you would be subject to exactly
the same fluctuations.
Mr Nicholson: If I could add to
that. The so-called October gas year is a legacy from the old
British Gas days. There is a slight peak in April as well in terms
of the proportion of the market that is contracting on that annual
basis. Companies could move away from it—in fact, I expect
a number probably are considering it precisely because of the
experience of what happened last year, but, of course, if that
peak just moves to another time in the year, I am not sure we
solve the problem. It is certainly a current feature of the market
but, arguably, if a large number of customers are coming to the
market at the same time as a large number of gas, there is no
particular reason why the price should necessarily be any higher.
Q45 Chairman: What if people say, "Right,
we want to avoid the September price likely rise" and just
go for spot market in the short term?
Mr Farrell: That has been a response
of a number of our members, particularly the larger intensive
ones that are in a better position—not necessarily an equal
position with all other gas market participants but a better position
than some—to monitor the markets. If you feel that the forward
market has in some senses gone awry and prices have taken leave
of fundamentals, then you would expect the spot market price will
not tend to deliver those sort of prices in any event. That is
certainly what has happened for this winter. But, of course, by
engaging in a spot market linked contract, you take on a degree
of risk, as a consumer, that would otherwise be borne by a supplier,
and a level of risk that is not borne by your Continental competitors.
Jeremy may want to add something to that.
Mr Robertson: I would like to
comment very specifically. The forward market prices in the UK
have been totally non-competitive—and they still are. If
you look at next winter, the forward market price today is around
45 pence a therm. That is at least 50% higher than the likely
outturn of prices linked to oil in the non-liberalised Continental
European market. Our customers require us to agree now to sell
product and they also require certainty of price—because
we operate in very competitive markets, competing internationally—and
if we simply, as we are being forced to do, take the risk of buying
spot, we have taken all the risk and the suppliers take none of
the risk. So the risk has been passed down the chain from the
producer/suppliers to large end-users. For companies who are owned
by overseas owners, that is very bad for investment, because our
chief executive in the States looks at what is happening in the
UK and is loathe to invest more money in plant improvement when
the future is so uncertain and when, as he sees it, we are taking
too much risk. But, alternatively, we cannot fix a price, simply
because to do so, we would be locking in a massive loss—which
we do not think will happen—because on the day the price
is cheaper. The biggest part of the problem is the forward market.
That is not to say the prompt market is working totally effectively
either, but the bigger part of the problem is the forward market,
and large intensive companies do need the ability to manage that
and not just to put everything to short-term spot prices.
Q46 Chairman: You say in your memorandum
that there is evidence of market failure and concentration of
market power. I wonder if you could spell this out in greater
detail and suggest the evidence you have to show that.
Mr Nicholson: We are aware that
the UK wholesale market, the production, is dominated by a relatively
small number of relatively large players—many of them vertically
integrated, as we heard from the evidence of energywatch. I think
you may also be hearing later on today from the Chemical Industries
Association, which has done a sort of Herfendal analysis of market
concentration suggesting it is a highly concentrated market. That,
in itself, does not necessarily mean there is a problem, but when
you add to that additional factors, such as the imbalance of information
available to consumers and independents in the market; barriers
to entry which we have heard about; and—an interesting feature
of the market—we know from gas producers that there are—and
I am choosing my words carefully, so please do not misinterpret
them—collaborative arrangements that would facilitate collusion.
We are not alleging that this has occurred, we do not have any
evidence to that effect—if we did, it would be with the
competition authorities—but we nonetheless have a structure
and a set of arrangements that would appear to facilitate it.
Indeed, we know from the Offshore Operators Association themselves
that their members—they would say quite properly, and maybe
rightly so—talk to one another about the quantity of gas
they need to land on the shore. There may be good reasons, for
security of supply and investment in the UK Continental shelf,
that these things go on, but it is nonetheless a feature of the
market and not the sort of features of the most competitive markets,
I would suggest.
Q47 Chairman: There is gas production
and there is wholesale and retail gas supply—three different
elements. Do you think there are enough players in this? Do you
think entry is too restrictive to get the kind of dynamic competition
that would cause the interaction to keep prices down?
Mr Nicholson: First of all, in
terms of production it depends what you mean by a number of players.
There is a tail, if you look at the distribution of very small
players, who are effectively price takers. So if you simply look
at the number of players in the market you do not get the whole
picture. There is a question of concentration in production and
certainly there could be barriers to entry there. On the supply
and retailing end, arguably the barriers are lower, and it is
not our contention that the problems lie there; it is more that
they lie upstream, in the wholesale end of the market. We have
heard the comments energywatch have made about regulation, the
disjunction, if you like, between where Ofgem's jurisdiction ends
and others', perhaps, either does or does not begin—we are
not quite sure—and of course the regulatory role that the
FSA, OFT, the European Commission and others might conceivably
play. So we have concerns about that. It may be that addressing
the regulatory regime may be one of the most productive ways of
addressing this problem.
Q48 Mr Clapham: Could I go back to the
contracts, Mr Farrell. We are talking in terms of them all coming
up for renewal in a given point in the year. We have heard Mr
Nicholson say that this is something we inherited from the old
British Gas days. Nevertheless, the fact that they require to
be renewed at that given part of the year does result in increases
or certainly the causing of spikes. How do we get away from that
if spot prices carry the kind of problems to which Mr Nicholson
has referred? That probably, because of that risk, would not be
the way to go. Is there another way that we might be able to avoid
the contracts coming to be renewed at given times of the year?
Mr Farrell: I think we have gone
through a very peculiar situation. I do not think the serious
spike this autumn was a function of the renewals. We had a serious
shortage of supply into the market for whatever reason. We had
almost rumour, scandal and gossip saying that we were going to
suffer a one-in-30 winter and we had a price spike as a consequence.
Our view would be that if you look at the spike in relation to
any other parameters, whether it is Continental prices or any
other baseline, it was not responding to fundamentals; it was
actually responding to the shortage of supply, speculation on
the margins of the market. Now, whether people settle at that,
whether they settle for one year or two years, is not going to
unduly influence the price. What has been happening—the
reason for the effect—is that when we were having that spike,
and if you went to buy not on the forward market but on the contract
market, you were actually paying a price set by the eight quarters
out, and, if the market was distorted and it was an artificially
high price, you were having to commit yourself to an artificially
high price for the period of the contract. So we had an odd situation,
where, if you were the company and you wanted to settle, if you
were going to renew your contract, it was at an artificially high
price; if you went on forward, it was the forward market that
was causing the problem; and, in the early part of it, for precisely
the same reasons but perhaps more short term, you did not have
the ability in the early stages to go into the spot.
Mr Robertson: May I add to that.
The way the market appears to work is that, when a large customer
goes to a supplier to try to enter a gas contract, the gas supplier
may well be the downstream of one of the vertically integrated
companies. That gas supplier will make an offering usually—and,
as an aside, one of the problems in the market is that all the
offerings tend to be very similar. But the offering is: "Yes,
we will sell you gas. These are the arrangements, and the price
will be whatever the market price is (ie, the spot market price),
and if you want, Mr Customer, to fix your price for a year or
two ahead, three months ahead, or whatever, we are willing to
offer you that facility, but we don't have any gas, we will have
to enter the forward market, the future's contract market, to
buy that gas for you on the forward market." I think one
of the biggest factors in the spike in the autumn was that, for
whatever reason, the supply of sellers of forward contracts did
not seem to be there, so there was an imbalance in the forward
market position—not an imbalance in physical gas. It is
very clear there is plenty of gas and there was no supply shortage
but there was an imbalance in the forward market contracts. That
is how it appears.
Q49 Mr Clapham: Would you speculate on
why that perceived shortage occurred?
Mr Robertson: I would certainly
say I am speculating. The Energy Intensive Users Group is actually
in discussion with the DTI about why the forward market, if I
may use the DTI's expression, "is not working as well as
it should be"—as opposed to the EIUG view that the
market is fundamentally broken. But part of the reason may be
due to subtle changes in taxation, part of the reason may be due
to market concentration and different strategies by the companies.
I mean, over the past six/seven years we have seen Chevron/Texaco
amalgamate, BP/Amoco/ARCO amalgamate, Total/Fina/Elf amalgamate,
so there is certainly a contraction, an aggregation. The other
area that we are talking on and investigating is to do with the
storage contracts. The UK has chosen, rather unusually relative
to the rest of Europe, to have negotiated third-party access for
storage—and I am talking specifically about Rough Storage
owned by Centrica—as opposed to regulated third-party storage.
That may also be an effect, inasmuch as the negotiations lead
to very high storage costs and then the market says, "Ah,
well, if storage costs are so high, the winter price is bound
to be high." Some people would argue it is chicken and egg
but it may be cause and effect. I am probably rambling slightly,
but there are a number of reasons being explored as to why that
effect, and I do not think anyone knows for sure.
Q50 Mr Clapham: May I turn to the underlying
impact on British industry. We know that the industry faces challenges
in changing world markets for its materials. Can British industry
continue to remain competitive with volatile changes in energy
prices?
Mr Farrell: On the scale we have
seen, no, and that is an absolute across all our sectors.
Q51 Chairman: Perhaps you could, for
the record, Mr Farrell and Mr Robertson, tell us the companies
who employ you. You represent companies within the British industrial
scene in manufacturing. Could you tell us who they are?
Mr Farrell: It is a very large
number. It is Royal Doulton; Wedgwood; major sanitary-ware
manufacturers like Standard; brick-makers; and it is one of the
biggest refractory companies in Europe. And it is across the spectrum,
across eight or nine sectors.
Mr Robertson: My employer is a
single company: Terra Nitrogen UK Limited, which produce fertilisers
and chemicals. I would say that a company like Terra can cope
quite adequately with volatility. Volatility is a feature of all
markets. The big concern for the UK is the uncompetitive nature
of prices, the fact that the UK gas price/the UK electricity price
has moved so dramatically out of line with Continental Europe
and we cannot understand why that is the case. I think there are
big companies who can cope with volatility, but it is the
uncompetitiveness of the prices.
Q52 Mr Clapham: Why is that, given that
Europe does not have a liberalised market like we do in the UK?
Mr Nicholson: That is exactly
what we want to know. Sometimes the excuse is given, "It
is all down to oil," but oil is an internationally priced
commodity. If oil were the explanation, we would not be seeing
a different effect here from there in order of magnitude terms.
What matters to businesses is the competitive position, not the
absolute level of prices. We understand prices go up in energy,
just as in any other commodity. In fact, I think it is correct
that the majority of large industrial gas sales in the Continent
are indexed to heavy fuel oil, which actually went down in price
slightly, I think, during 2004, so it did not experience anything
like the price rises that we saw in dollar-denominated crude oil,
for example. It is this competitiveness gap opening up that is
a matter of concern to us. Why should this be happening, when
we are certainly moving towards becoming a net importer on an
annual basis of gas? But, so what? Most of Europe is a net importer
of gas—some of them right the way through the year—so
that in itself is not an explanation either. We have a liberalised
market, an allegedly competitive one, and yet we seem to have
prices that do not reflect fundamentals. One point on the state
of competition in our market: DTI regularly publishes an annual
report assessing the level of competition in energy markets in
the UK and other European comparators. What it publishes is factually
correct, but when they say, "We have got a competitive market,"
they mean: "We have x number of people competing, not necessarily
delivering internationally competitive prices." It is a bit
like the situation we had in cars, 10 or 20 years ago, when lots
of people were allegedly competing with one another to sell you
a car at 30% or 40% more than it cost in Belgium or Germany. It
is a bit like that with gas at the moment. The picture we are
getting from some of the official statistics does not seem to
tell the whole story about whether the prices themselves are competitive,
and, of course, that is what matters to our businesses, in the
sectors and companies you have heard of, and others: sectors like
glass, with companies like Pilkington, and steel, with companies
like Corus. These are real issues to them.
Q53 Mr Clapham: Would it be fair to say
that in a less liberated market like Europe there is greater predictability
of price because governments are now prepared to intervene?
Mr Nicholson: I am not sure whether
it is directly government intervention per se. Certainly
one or two governments are not proceeding with liberalisation
as we would hope. That actually raises security of supply concerns
as well as it does pricing ones. I hope you have not taken from
any of our comments either orally or in our written evidence that
we are asking for formal intervention. We are looking for a review
of the regulatory regime and for improvements to market efficiency.
But we support markets: we are not asking for price caps or anything
like that.
Mr Farrell: If you break it into
two issues—and we hope they are the two issues, in some
senses, that you are going to look at throughout the hearing—the
first is what has happened quite precisely within the markets,
and particularly the forward market, and why we have had the undersupply
and why we have then had a situation in which higher prices have
been set by a very low volume of trade. The second issue is the
way then the prices are set across the whole of the market, piggy-backing
on the higher prices, so that the higher spot or forward prices
are then reflected in the contract prices. It is almost as if
the whole market moves in unison and is actually being driven
by an apparent shortage of supply—speculation—which
has created a market that malfunctions.
Q54 Mr Clapham: And of course it is interesting
to make a comparison with Europe.
Mr Farrell: Oh, yes.
Q55 Sir Robert Smith: Could I just clarify.
You said from your information that in mainland Europe the relationship
is with heavy oil. But we have been advised that actually it is
with gas oil.
Mr Nicholson: There is a mixture
there. The information we have for the very large industrial consumers
is that typically the weighting in the contract is either all,
or heavily towards, heavy fuel oil. Sometimes it is in conjunction
with gas oil, which, as I am sure you appreciate, tends to track
crude oil prices much more strongly. I think there may be an element
of gas that is on a crude index basis.
Mr Robertson: We can provide more
written evidence on that point. It is certainly the case that,
for example, Hassuni in Holland used to price all its gas to large
industrial consumers against low sulphur heavy fuel oil, so it
was 100%. The price of low sulphur fuel has been relatively weak,
very weak
Q56 Sir Robert Smith: Because of all
the environmental concerns?
Mr Robertson: Possibly, yes, but
also because of changes in consumption in other parts of the world.
As a result of that, it is certainly the case that, as I understand
it—though you would have to question them directly—Hassuni
is striving to introduce a more balanced indexation for large
users which is 50% gas oil, 50% low-sulphur heavy fuel oil. But
most of the existing contracts, like Troll from Norway into a
couple of countries and from Algeria, have more low sulphur heavy
fuel oil in the indexation than gas oil to the best of our knowledge.
As I say, we can provide the sources of that information.
Q57 Sir Robert Smith: You were saying
that it should be an open market, but is it not the reality that,
if you had a really cold winter here, the Interconnector would
be at full speed, and once it reaches peak capacity you no longer
have a connecting market. You then have a supply and demand problem
within a closed market for the UK. And if you had a one-in-30
winter, what would the spot price be?
Mr Nicholson: That is an interesting
question. I am not sure I could answer what the spike price would
be, but it would plainly be a lot higher than we have been experiencing
this winter. You are right that there are constraints on the Interconnector
capacity, and I think it is important, from a physical point of
view as well as a market point of view, that the Interconnector
capacity is in the process of being upgraded. As I am sure you
will appreciate, we have an asymmetry of flow capabilities in
the Interconnector, so, if you like, we get the "advantage"
of an increase in demand in the UK feeding through to the Continent
during the summer and less of an `advantage' in terms of security
of supply in the winter, and that is starting to change.
Q58 Sir Robert Smith: Is that not, in
a sense, because people have looked at these forward prices and
said, "Hang on a minute, if there is an increase in the capacity
there is a market there to be served," and so the forward
prices have sent a signal to the market and the market is now
responding.
Mr Nicholson: You are certainly
right that the market is responding in terms of investment, but
of course a lot of that response actually occurred way before
the massive price rises we saw last year, including, of course,
work starting on the hugely important link from Norway.
Q59 Sir Robert Smith: You have mentioned
already the relationship with Europe and how you do not want to
go down the road of government intervention. Regulators would
argue—and maybe this is more for less intense users—that
having had this open and wonderful market in this country in the
good times, industry and commerce have done better than their
competitors on mainland Europe. Is that a fair argument?
Mr Nicholson: Yes, but there seems
to be a disproportional impact going the opposite way. And that
is exactly the problem. If we were all convinced, by the way,
that European liberalisation was immediately round the corner
and we would have instantly competitive prices and the questions
of our medium- to long-term security of supply in gas were therefore
answered as well, perhaps we could all live with it. It is not
progressing according to plan. The most optimistic estimate suggests
we are several years away from liberalisation and the sort of
competitive impacts we are seeing for our members are not something
that can be tolerated for that length of time. That is an optimistic
scenario. A pessimistic scenario—some would say a realistic
one—is that things are not moving to plan in electricity
and they are even worse in gas. We feel as a matter of urgency
that the DTI, whilst we support them all the way in pressing for
liberalisation, should be considering a fallback position if,
for whatever reason, that plan does not proceed according to expectations.
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